CR_indAB

8/2/2019 CR_indAB

1/68

CUTS Centre for

Competition, Investment

& Economic Regulation

Discussion Paper

#0332

Investment Policy in India Performance and Perceptions

8/2/2019 CR_indAB

2/68

Investment Policy in India Performance and Perceptions

CUTS Centre for Competition,Investment & Economic Regulation

8/2/2019 CR_indAB

3/68

Investment Policy in India Performance and PerceptionsPublished by:

CUTS Centre for Competition, Investment & Economic RegulationD-217, Bhaskar Marg, Bani Park, Jaipur 302 016, IndiaPh: +91.141.220 7482, Fax: +91.141.220 7486Email: [email protected], Website: www.cuts.org

In Association With

National Council of Applied Economic ResearchParisila Bhawan, 11 Indraprastha Estate, New Delhi 110 002Ph: +91.11.2337 9861-63/65, Fax: +91.11.2332 7164/9788Email: [email protected], Website: www.ncaer.org

Acknowledgement: This report* is being published as a part of the Investment for Development Project, withthe aim to create awareness and build capacity on investment regimes and internationalinvestment issues in seven developing and transition economies: Bangladesh, Brazil,Hungary, India, South Africa, Tanzania and Zambia. It is supported by:

Copyright: CUTS, 2003

The material in this publication may be reproduced in whole or in part and in any formfor education or non-profit uses, without special permission from the copyright holders,provided acknowledgment of the source is made. The publishers would appreciatereceiving a copy of any publication, which uses this publication as a source.

No use of this publication may be made for resale or other commercial purposeswithout prior written permission of CUTS.

Citation: CUTS, 2003, Investment Policy in India Performance and Perceptions

Printed by: Jaipur Printers P. Ltd., Jaipur 302 001

ISBN 81-8257-007-7

*Other country reports are also available with CUTS

#0332 SUGGESTED CONTRIBUTION INR100/US$25

DFIDDepartment forInternationalDevelopment, UK UNCTAD

8/2/2019 CR_indAB

4/68

Contents

Foreword ........................................................................................................................ 8

Preface .......................................................................................................................... 10

Introduction .................................................................................................................. 12

1. Overview of Macroeconomic Context ................................................................... 15

1.1. Market Size and Growth ...................................................................................... 15

1.2. Rates of Interest and Inflation .............................................................................. 15

1.3. Investment Inflow ................................................................................................. 17

1.4. Balance of Payments: Capital and Current Accounts .......................................... 22

2. Overview of Main Policy Trends............................................................................. 25

2.1. Economic Reforms in India .................................................................................. 25

2.2. Membership in International and Regional Trade Agreements .............................. 26

2.3. Capital Controls: Capital Account Liberalisation .................................................. 26

3. Investment Policy Audit .......................................................................................... 31

3.1. Liberalisation of Inward FDI Policies .................................................................... 31

3.2. Entry and Establishment ..................................................................................... 32

3.3. Registration Procedure ........................................................................................ 32

3.4. Repatriation of Profits .......................................................................................... 35

3.5. Investment Facilitation Initiatives/Institutions ....................................................... 35

4. Evaluation of Foreign Investment Policy Regime ................................................ 37

4.1. Regime for FDI .................................................................................................... 37

4.2. Policy Regime: the Reality .................................................................................. 38

5. Analysis of Civil Society Surveys ........................................................................... 43

5.1. Introduction ......................................................................................................... 43

5.2. Sectoral Destination of FDI .................................................................................. 43

5.3. Impact of FDI ....................................................................................................... 44

5.4. Indias Experience with FDI Flows ....................................................................... 44

5.5. General Policy Implications ................................................................................. 46

6. Case Studies ............................................................................................................ 49

6.1. The IT Sector ....................................................................................................... 49

6.2. Automobile Sector .............................................................................................. 52

6.3. The Power Sector ................................................................................................ 55

Conclusion ................................................................................................................... 61

Annexure...................................................................................................................... 63

Bibliography ................................................................................................................ 64

Endnotes....................................................................................................................... 66

8/2/2019 CR_indAB

5/68

List of Tables

Table 1: Growth Rate of GDP and Industrial Production in India ..............................................................15

Table 2: Domestic Prime Lending Rates ................................................................................................. 16

Table 3: Domestic Inflation Rates ...........................................................................................................17

Table 4: Total Foreign Investment Inflows over the 1990s ........................................................................ 18

Table 5: Industry Distribution of FDI Approvals Between 1991-2001 ........................................................ 19

Table 6: Actual FDI Inflow into India in the 1990s ....................................................................................19

Table 7: Sectoral Distribution of Foreign Direct Investment......................................................................20

Table 8: FDI Inflow & Cross-border Acquisitions in India, 1991-December 1998 ......................................21

Table 9: Number of Technical and Technical-cum-Financial Foreign Collaborations in India ..................... 21

Table 10: Indias Overall Balance of Payments ......................................................................................... 22

Table 11: Exchange Rate of Rupee & Foreign Exchange Reserves of RBI. ............................................... 23

Table 12: Savings, Investment Rates, Current Account (CAD) & Trade Deficit (TD);

as Percentage of GDP in Current Prices ................................................................................... 24

Table 13: Significant Regulatory Changes Involving FII in India over 1990s ................................................ 29

Table 14 Proposed Changes in Sectoral Limits on FDI .......................................................................... .. 40

Table 15: Negative Perceptions of Civil Society......................................................................................... 45

Table 16: Positive Perceptions of Civil Society .......................................................................................... 45

Table 17: Civil Societys Inclination towards FDI ....................................................................................... 46

Table 18: Policies to Increase the Benefits of FDI ..................................................................................... 47

Table 19: Growth of Indian Software Industry Revenues ............................................................................ 50

Table 20: Automobile Industry- Selected Statistics ...................................................................................52

Table 21: Index of Concentration, Market Size and Domestic

Consumption of Various Segments of Auto industry .................................................................. 54

8/2/2019 CR_indAB

6/68

6wInvestment Policy in India Performance and Perceptions

Acronyms

ADRs American Depository Receipts

CAD Current Account Deficit

CBU Completely Built Unit

CCFI Cabinet Committee on Foreign Investment

CEA Central Electricity Authority

CKD Completely Knocked Down

CMM Capability Maturity Model

CUTS Consumer Unity & Trust Society

DFID Department for International Development

DGFT Director General of Foreign Trade

DPC Dabhol Power Company

ECB External Commercial Borrowing

EEFC Export Earners Foreign Currency

EPZ Export Processing Zone

ESI Electricity Supply Industry

FCB Foreign Currency Bond

FCCB Foreign Currency Convertible Bonds

FCRC Foreign Controlled Rupee Companies

FDI Foreign Direct Investment

FERA Foreign Exchange Regulation ActFI Financial Institution

FIIs Foreign Institutional Investors

FIPB Foreign Investment Promotion Board

FIPL Foreign Investment Promotion Law

FPO Fruit Product Order

GDI Gross Domestic Income

GDP Gross Domestic Product

GDR Global Depository Receipt

IDBI Industrial Development Bank of IndiaIIA International Investment Agreement

IFD Investment for Development

IMF International Monetary Fund

IPP Independent Power Producer

IPR Intellectual Property Rights

IRDA Insurance Regulatory and Development Authority

IS Import Substitution

IT Information Technology

8/2/2019 CR_indAB

7/68

Investment Policy in India Performance and Perceptionsw 7

JV Joint Ventures

MNE Multinational Enterprise

MoU Memorandum of Understanding

MRTP Monopolies and Restrictive Trade Practices

MSEB Maharashtra State Electricity Board

MUL Maruti Udyog Ltd.NASSCOM National Association of Software and Service Companies

NEP New Economic Policy

NIE Newly Industrialised Economy

NRG National Reference Group

NRI Non-resident Indian

OCBs Overseas Corporate Bodies

ODA Overseas Development Assistance

OEM Original Equipment Manufacturers

PLF Plant Load FactorPLR Prime Lending Rate

QR Quantitative Restrictions

RBI Reserve Bank of India

REER Real Effective Exchange Rate

RoE Return on Equity

SAARC South Asian Association for Regional Cooperation

SAFTA South Asian Free Trade Arrangement

SAPTA Agreement on SAARC Preferential Trading Arrangement

SBA Stand-by ArrangementSEBs State Electricity Boards

SEI Software Engineering Institute

SEZ Special Economic Zones

SIA Secretariat of Industrial Assistance

SKD Semi Knocked Down

SOE State-owned Enterprise

SSI Small Scale Industry

STP Software Technology Parks

TD Trade Deficit

TEC Techno-economic Clearance

TI Texas Instruments

TRAI Telecom Regulatory Authority of India

TRIPs Trade Related Intellectual Property Rights

UNCTAD United Nations Conference on Trade and Development

WOS Wholly Owned Subsidiaries

WPI Wholesale Price Index

WTO World Trade Organisation

8/2/2019 CR_indAB

8/68


Foreword

India continued with its receptive attitude towards FDI for about a decade after it gainedindependence in 1947. This was on account of limited domestic base of created assets viz.,

technology, skills and entrepreneurship. During this period foreign investors were assured offree remittances of profits and dividends, fair compensation in the event of acquisition, andwere promised national treatment. However, the second five-year plan (1956-61) made asignificant departure by emphasising self-reliant economic development and adopting a restrictiveattitude towards FDI in order to protect the domestic base of created assets. Further in 1973,the Foreign Exchange Regulation Act (FERA) came into force which prescribed a ceiling of 40percent in equity by foreigners in Indian companies. This resulted in many foreign companiesleaving India in the late 1970s.

However, there was a reversal in the policy stance during 1980s. The liberalisation of industrialand trade policies during this decade was accompanied by an increasingly receptive attitudetowards FDI and foreign collaborations. In order to modernise the Indian industry greater role

was sought to be given to trans-national corporations (TNCs). Further, exceptions from thegeneral ceiling of 40 percent on foreign equity were allowed on the merits of individual investmentproposals.

Riding on the wave of reforms, full-scale liberalisation measures were initiated in 1990s with aview to integrating the Indian economy with the world economy. The policy allowed automaticapproval system for priority industries by the Reserve Bank of India. For the purpose of grantingautomatic approval three slabs of foreign ownerships were defined viz., up to 50 percent, up to51 percent and up to 74 percent. Albeit such limits were relaxed year after year. For instance,in some sectors, up to 100 percent foreign investment on automatic basis is allowed now.

Foreign Investment Promotion Board (FIPB) was set up to process applications for cases notcovered by automatic approval. Replacement of FERA by Foreign Exchange Management

Act (FEMA) removed shareholding and business restrictions on TNCs. Further policies relatingto foreign technology purchase and licensing were liberalised to improve access to foreigntechnology. Finally, outward investments by Indian enterprises were liberalised and proposalssatisfying certain specified norms were given automatic approval. These changes in nationalFDI policies were complemented by bilateral investment treaties (BITs) and double taxationavoidance treaties (DTATs), many of which have been signed by India in recent years.

Foreign investment started pouring in after India launched its liberalisation programme in 1991.However, Indias performance in terms of attracting foreign investment has not been veryencouraging. Indias inward FDI stock as a percentage of GDP in 2001 stood at 4.7, one of thelowest in the world. The factors that determine location decision of the TNCs, which makemost of FDI may be tax structure, special programmes and schemes, competition regime,

entry and establishment requirements, investment protection, technology transfer, naturalresources and skill levels, incentives and institutional mechanism. However, what actuallydetermines the flow of FDI (and how) is quite a complex issue. For example, on most of theseaccounts, India may look to be more attractive than China, but fails to attract even one-tenthof FDI inflows that China receives.

It is however often argued that such great enthusiasm towards attracting FDI shown by mostdeveloping countries is more because of ideological factors rather than changes on the ground.It is also widely recognised that receiving more FDI is not the route for development in developingcountries. China has maintained high GDP growth along with huge FDI flows.

8/2/2019 CR_indAB

9/68


Brazil, however, has shown lacklustre economic performance despite an impressive record inattracting FDI. India, on the other hand, managed to perform reasonably well in terms of GDPgrowth despite its poor performance in attracting FDI. The issue, therefore, needs carefulanalysis.The challenge before India is not only to attract more FDI that matches its size andpotential but also to get quality FDI that fosters development. It is therefore important tocarefully look at the different aspects of FDI and its impact. For each of the stakeholders it isimportant to understand the issues so that they can play their appropriate role in fostering

development through FDI. The present volume would hopefully contribute in promoting suchunderstanding and awareness.

November 2003 Pradeep S. MehtaSecretary General

8/2/2019 CR_indAB

10/68


Preface

Many developing countries, once hostile to the entry of foreign direct investment (FDI) orinclined to restrict it severely, now compete to attract foreign firms. Experience with thedevelopment process over the last couple of decades is partly responsible for these attitudes.Foreign investment operating through multiple channels is seen as an important tool for raisingproductivity in the economy. There are other reasons for this change in attitude.

Firstly, there has been a rise in multinational enterprises (MNEs), which command over themost productive segments of the world economy. Recent evidence indicates that workers inMNE affiliates produce about seven times as much as the national average output per worker.The margin in developing countries is even greater, perhaps as much as 15 times the averageoutput per worker. Thus MNEs are highly productive firms, and their operations in host countries

reflect the productivity of the parent firms. Indeed MNE plants in emerging markets are oftenthe world leaders in productivity.

Secondly, FDI may increase productivity of capital in the host country more widely byintroducing methods of production more efficient than those of local firms. Moreover, FDIpromotes growth by introducing new industries into the host country and into its portfolio ofexport products.

Another source of productivity gains for the host country, which has received considerableresearch attention, is the possibility of so called spillover effects: productivity advances passingfrom foreign affiliates to locally owned firms. Locally owned firms might increase their efficiencyby copying foreign firms (such as through marketing/managerial know-how) to raise profits,

reach export markets, or merely survive in the domestic market.

It should be noted that most of the benefits are more likely to accrue if the domestic marketremains competitive, rather than being monopolised by either domestic players or individualmultinationals.

In the light of the importance of FDI in the framework of developing countries, Consumer Unity& Trust Society (CUTS), Jaipur with the support of Department for International Development(DFID), UK and, in collaboration with the United Nations Conference on Trade and Development(UNCTAD) has undertaken a study to analyse the investment regimes of seven developing /transition economies and build capacity of civil society on these issues. The emphasis is onco-operation between countries and within regions, sharing information and experience andengineering joint initiatives. The National Council of Applied Economic Research (New Delhi)

is working with CUTS as the partner organisation in India. I would like to thank CUTS for itscontinuing partnership with NCAER in areas of common interest.

This report attempts to study the investment regime and actual performance of India with aview to build capacity and awareness in investment issues and draw out the lacuna of thepresent system. The study is based on existing literature along with feedback obtained fromsurveys of stakeholders, namely civil society groups and local firms.

I would like to thank Dr. Sanjib Pohit and Ms. ShaliniSubramanyam for their hard work inpreparing this report.

8/2/2019 CR_indAB

11/68


Authors have benefited from the participants comments at the second and third NRG meetingsheld in June 2002 and March 2003 respectively and the Asia-Pacific Regional Meeting held at

New Delhi in November 2002. We have also gained from the participants comments at theInternational Conference on Investment for Development, 9-10 May 2003, Geneva, Switzerland.We would also like to thank John.H.Dunning - Emeritus Professor of International Business,University of Reading, UK and Pradeep Mehta - Secretary General, CUTS for their thoughtfulcomments. We are grateful to Aradhna Agarwal, Senior Fellow, Indian Council for Researchon International Economic Relations (ICRIER) and Richard Eglin of the World Trade Organisationfor reviewing the paper. We have benefited from the comments provided by Laveesh Bhandariof Indicus Analytics, New Delhi and the CUTS team. Finally NCAER would like to thankPraveen Sachdeva for Computer and Design Support.

Portion of the report has been taken from two other reports prepared for the CUTS-Investmentfor Development Project namely, Report A: Investment Policy - India (authored by Biswatosh

Saha of Xavier Labour Relations Institute (XLRI), Jamshedpur, India) and Report B: Perceptionsof Impact of FDI on Economy (authored by Poonam Munjal, Sanjib Pohit and ShaliniSubramanyam).

November 2003 Suman BeryDirector General

National Council of Applied Economic ResearchNew Delhi, India

8/2/2019 CR_indAB

12/68


Introduction

Since the 1980s, a consensus has been growing, even among the

developing countries, that the net result of foreign direct investment (FDI)can be positive. The phenomenal drop in total Overseas DevelopmentAssistance (ODA) in the 1990s has also forced most of the countries toincreasingly look at FDI as an alternative source for financing development.It is considered to be a better option compared to bank credit, becauseof high and variable interest rates, and portfolio investment, which carriesits own risks. It is also being considered as the principal channel for thetransfer of long-term private capital, technology and managerial know-how, as well as a link between national economies and the world market.

The importance of FDI in development has dramatically increased in recentyears. FDI is now considered to be an instrument through whicheconomies are getting integrated at the level of production into the globaleconomy by accessing a package of assets, which include capital,technology, managerial capacities and skills, and foreign markets. It alsostimulates technological capacity building for production, innovation andentrepreneurship within the larger domestic economy through catalysingbackward and forward linkages1 .

The trade effects of FDI depend on whether it is undertaken to gain accessto natural resources or consumer markets, or whether FDI is aimed atexploiting locational comparative advantage and other strategic assetssuch as research and development capabilities2 . By its very nature, FDIbrings into the recipient economy resources that are only imperfectlytradable in markets, especially technology, management know-how, skilled

labour, access to international production networks, access to majormarkets and established brand names. In addition, FDI can make acontribution to growth in a more traditional manner, by raising theinvestment rate and expanding the stock of capital in the host economy.It has thus been widely recognised by governments that FDI could play akey role in the economic growth and development process.

Glancing back at the pages of history, India, if not completely hostile,wasnot very receptive to foreign private capital. Long cherished dreams of thenationalists to build strong home-grown champions and apprehensionsabout FDI eroding sovereignty and culture dominated Indian economicscenario. Today, such fears look vastly overblown, and the Indian policy-makers openly welcome FDI.

Though the Government of India has been trying hard these days to attractFDI, the flows into India as a share of Gross Domestic Product (GDP)have been much more modest than many other developing countries.

In the light of this shift in policy regime and Indias inability to attract FDIin a big way, this report attempts to study the investment regime andactual performance of India with a view to build capacity and awarenessin investment issues and draw out the lacuna of the present system.The study is based on existing literature along with feedback obtainedfrom surveys of stake holders, namely civil society groups, and localfirms.

FDI is now considered to be aninstrument through which

economies are being integrated atthe level of production into theglobal economy by bringing a

package of assets.

Glancing back at the pages ofhistory, India if not completely

hostile,was not very receptive toforeign private capital. Today, the

Indian government is openlywelcoming foreign direct

investment. Though the

Government of India has beentrying hard to attract FDI, the flows

in India (as a share of GrossDomestic Product) have been

modest.

8/2/2019 CR_indAB

13/68


The report is organised in the following manner: Chapter 1 gives a broadmacro-view of India in recent years, while Chapter 2 discusses the mainpolicy trends since launching of the economic reforms in 1991. In Chapter3 the discussion on Investment Policy Audit, highlights the parametersof investment policy, including registration, rights to entry andestablishment, investor protection, dispute settlement, internationalinvestment agreements, taxation, movement of capital, intellectual

property rights regime, performance requirements, incentives for investmentand export, characteristics of the regulatory regime, etc. In Chapter 4, anattempt is made to evaluate the present investment policy regime. Chapter5 examines the perception of the civil society on FDI flows, impact of FDIon specfic sectors, means to increase FDI flows and benefits thereof.Chapter 6 follows up the Indian experience of FDI inflows with three casestudies. Finally, the conclusion summarises the main findings.

8/2/2019 CR_indAB

14/68


8/2/2019 CR_indAB

15/68


CHAPTER-1

Brief Overview of Macroeconomic Context

1.1. Market Size and Growth

In terms of the overall market size of the economy (as measured by GDPat current market prices), Indias GDP was around US$510bn in 2000-01. A cursory look at Table 1 illustrates that the growth rate of both GDPand industrial production shows a decline to very moderate levels in thelate 1990s after a brief spurt in the mid-1990s.

There has been a debate among economists centring on the growthperformance of the economy in the post reform period. While the morepopular view is that growth has accelerated after the implementation of

the reforms package, Nagaraj (2000), after a more robust statisticalanalysis of growth rates of GDP and its various components using datafor 1980-2000 argues that there is no significant increase in the trendrate of growth of GDP in the 1990s. According to this estimate, the averagegrowth rate during 1980-81 to 1999-2000 was 5.7 percent while the sameduring 1980-81 to 1990-91 was 5.6 percent. In fact, a statisticallysignificant decline in the secondary sector can be identified over the lastdecade, i.e. post reforms.

1.2. Rates of Interest and Inflation

1.2.1. Rates of Interest

Table 2 shows the movement of nominal interest rates of scheduledcommercial banks in India over the 1990s. Over the 1980s, interest rateswere regulated, the prime lending rate (PLR) of State Bank of India (thelargest scheduled commercial bank) being pegged at about 16 percentand that of Industrial Development Bank of India (IDBI, which is a termlending institution; also called a financial institution, FI) pegged at 14

percent. Domestic interest rates were raised sharply in mid-1991, as aresult of the monetary contraction that was part of the InternationalMonetary Fund (IMF) style stabilisation package. Mid-1992 onwards,however, interest rates were slowly brought down to lower levels, thedeclining trend continuing till date.

Since October 1994, banks were allowed freedom to set their own lendingrates for most categories of advances. As a result, different banks startedannouncing different lending rates according to their own businessjudgements so data for the later period shows the range within whichPLRs of the five largest scheduled commercial banks in the country varied.As the data in Table 2 show, the declining trend in nominal interest rateswas reversed in early 1995.

Table 1: Growth Rate of GDP and Industrial Production in India (in percent)

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-01

GDP growth 6.2 7.8 7.2 7.8 4.8 6.6 6.4 5.2

Growth in IIP* 6 8.4 12.7 6.1 6.6 4.1 6.7 5.1

Source: RBI Annual Report, various issues *Index of Industrial Production

While the popular view is thatgrowth has accelerated after the

implementation of the reformspackage, Nagaraj argues that

there is no significant increase inthe trend rate of growth of GDP in

the 1990s.

Domestic interest rates were raisedsharply in mid-1991, as a result of

the monetary contraction that waspart of the International MonetaryFund style stabilisation package.

Mid-1992 onwards, however,interest rates were slowly brought

down to lower levels, the decliningtrend continuing till date.

8/2/2019 CR_indAB

16/68


It is worth mentioning here that banks could set their lending rates freelyfrom October 1994, and this rise in interest rates was, perhaps, a reflection

of banks strategy. This was mainly because recovery in industrial growthin 1994-95 and 1995-96 resulted in rising demand for credit from industryfrom around early 1995.

Though Reserve Bank of India (RBI), in general, has tried to bring downthe interest rate structure, its efforts were circumvented every time dueto depreciation in the foreign exchange market forcing it to raise short-term domestic interest rates (in order to encourage inflow of foreignexchange through banking channels as well as from exporters/importers).

Table 2: Domestic Prime Lending Rates (% per annum)

Year Average interest rates

1990-91 16.5

1991-92 16.5

1992-93 19.0

1993-94 19.0

1994-95 15.0

1995-96 16.5

1996-97 14.5

1997-98 14.0

1998-99 13.0

1999-00 12.0

2000-01 11.9

2001-02 11.5

2002-03 11.3

Source: RBI Annual Report, various issues

1 Figures relate to the minimum PLR among the 5 major scheduled commercial banks during theperiod. Real interest rates were calculated using annual average inflation rates formanufactured goods.Source: RBI Annual Report, various issues

0

2

4

6

8

10

12

14

4/13/91 4/13/92 4/13/93 4/13/94 4/13/95 4/13/96 4/13/97 4/13/98 4/13/99

%perannum

Figure 1: Real Prime Lending Rates in India in the 1990s. (Figures in %)1

8/2/2019 CR_indAB

17/68


1.2.2. Rates of Inflation

Of course, it is real rather than nominal interest rates that are of importanceas far as economic activity is concerned. Table 3 shows different measuresof inflation in the economy through the 1990s. Figure 1 plots the trends inmovement of real interest rates using the average annual changes ofprice of manufactured goods to derive the real rates. As shown in figure1, real interest rates remained high, at more than 8 percent, through

most of the 1990s - except for a brief period in 1994-95, when real ratesdeclined to about 4-6 percent. So, the decline in nominal rates in thelater half of the 1990s was not accompanied by a decline in real rates asinflation rates, especially that for manufactured goods, fell sharply duringthat period.

The high real rates of interest prevailing in the domestic economy createsa cost of capital disadvantage for domestic enterprises, vis--vis theirforeign competitors, headquartered in economies with lower interest rates,which can translate into a strategic disadvantage as well. Domesticbusiness groups and chambers of commerce have, in fact, beencomplaining about the high cost of capital that they are facing over thelast decade.

1.3. Investment Inflow (1992-2001)

After the liberalisation of capital controls in 1991, there has been asubstantial increase in the inflow of foreign investments into India. Table4 gives the year-wise break-up of foreign investment inflows. Thoughliberalisation in the foreign investment regime for direct investment occurredin July 1991 and for portfolio investment in September 1992, foreigninvestment inflows picked up in earnest only from the last quarter of1993. As Table 4 indicates, FDI as percent of GDP has increasedsignificantly in the last decade.

Table 3: Domestic Inflation Rates1

All commodities Manufactured products

Point to point Average Point to point Average

1990-91 12.1 10.3 8.9 8.4

1991-92 13.6 13.7 12.6 11.3

1992-93 7.0 10.0 7.9 10.9

1993-94 10.8 8.3 9.9 7.8

1994-952 10.4 10.9 10.7 10.5

1995-962 5.0 7.8 5.0 9.1

1996-972 6.9 6.4 4.9 4.1

1997-98 5.3 4.8 4.0 4.11998-992 4.8 6.9 3.7 4.5

1999-2000 6.5 3.3 2.4 2.7

2000-2001 4.9 7.2 3.8 3.1

2001-02 1.5 3.6 0.5 1.9

2002-03 6.5 3.4 5.4 2.61 Figures based on Wholesale Price Index (WPI) calculated by RBI with base 1981-82 = 1002 Figures from 1994-95 onwards are based on the new WPI series with 1993-94 = 100Source: RBI Annual Reports, various issues

The high real rates of interestprevailing in the domestic economy

creates a cost of capitaldisadvantage for domestic

enterprises, vis--vis their foreigncompetitors, headquartered in

economies with lower interest rates,which can translate into a strategic

disadvantage as well.

8/2/2019 CR_indAB

18/68


However, portfolio investment did not show a consistent trend after 1995and even touched a negative figure in 1998 and then again startedincreasing in 1999-2000 followed by marginal decline in 2000-2001.Movement in direct investment flow reflected considerable rise fromUS$6mn in 1990-91 to US$4784mn in 1997-98, but beyond 1998 therecame a brief period of downtrend. But soon resurgence came with a risein FDI to US$5102 in 2000-01.

It must be mentioned that the definition of FDI and computation of FDIstatistics used by Reserve Bank of India (RBI) does not conform to the

guidelines of the IMF. Some of the main discrepancies are that Indiaexcludes reinvested earnings in its estimate of actual FDI inflows. It doesnot include the proceeds of the foreign equity listings and foreignsubordinated loans to domestic subsidiaries which, according to IMFguidelines, are part of inter-company loans (long- and short-term net loansfrom the parents to the subsidiary) and which should be a part of FDIinflows. India also excludes overseas commercial borrowings, whereasaccording to IMF guidelines financial leasing, trade credits, grants, bonds,etc should be included in FDI estimates.

Recently, the government has reorganised FDI data for 2000-01, 2001-02, and 2002-03 along the lines recommended by the IMF, to includesome uncaptured elements of capital, to end under-reporting of FDI.3

The new formula would include control premiums, non-competition fees,reinvested earnings and intercorporate borrowings as FDI.

1.3.1. Approved and Actual Inflows of FDI

After the liberalisation of entry norms for foreign investors in India in 1991,FDI flows into the economy have increased, especially in comparison tothe levels of inflow experienced prior to 1991. Table 5 summarises theindustry-wise distribution of foreign collaboration approvals granted overthe 1990s (between August 1991 and August 2001). The total approvedamount of FDI in these proposals was US$56.5bn.4 Only about 8

Table 4: Total Foreign Investment Inflows over the 1990s in US$mn

90-91 91-92 92-93 93-94 94-95 95-96 96-97 97-98 98-99 99-00 00-01

Direct Investment - - 280 403 872 1419 2058 2956 2000 1581 2342

Portfolio Investment 6 4 244 3567 3824 2748 3312 1828 -61 3026 2760

Total 6 4 524 3970 4696 4167 5370 4784 1939 4607 5102

FDI as % of GDP 0.03 0.05 0.14 0.21 0.41 0.60 0.73 0.87 0.59 0.48 0.49

FDI as % of GDI 0.12 0.21 0.55 0.93 1.57 2.25 2.99 3.47 2.56 2.05 2.08

Source: Report B

Box A: FDI Definition Widened

The composition of balance of payments would change after the inclusion of these items

although it would not alter the balance of payments for the last three financial years.

Component-wise revised FDI data (in US$mn)

Year Equity Reinvested Other FDI Inflows toIndia FDI Inflows to India DifferenceEarnings Capital Revised Data Current Data

2000-01 2400 1350 279 4029 2342 1687

2001-02 4095 1646 390 6131 3905 2226

2002-03* 2700 1498 462 4660 2574 2086

Source: Business Standard, July 1, 2003.

* Figures for 2002-03 are estimates.

8/2/2019 CR_indAB

19/68


Table 5: Industry Distribution of FDI Approvals Between 1991-2001

No. of Approvals Amount of FDI Percent of TotalIndustryApproved (US$mn) Amount Approved

Metallurgical industry 314 3076 5.44

Fuels 575 16004 28.32

Power 229 7909 14

Oil Refinery 136 5206 9.21Computer software 1846 1206 6.39

Electronics 303 677 1.2

Telecommunications 617 11269 19.94

Transportation industry 768 4033 7.14

Chemicals

(other than fertiliser) 852 2641 4.67

Drugs 225 573 1.01

Textiles 561 718 1.27

Paper and pulp 116 682 1.21

Food processing 662 1879 3.32

Services 838 3493 6.18 Financial services 370 2388 4.23

Hotel & Tourism 324 1019 1.8

Total 13028 56511 100

All approvals given between August 1991 and August 2001 have been included. Data includes

approvals given through FIPB for GDR/FCCB issues.

Note: Approved amount of FDI is calculated using Exchange rate prevailing in the month of Aug 2001

Source: Secretariat of Industrial Assistance Newsletter, August 2001, Ministry of Industry, Government of

India

Table 6: Actual FDI Inflow into India in the 1990s (in US$mn)

1991 1993 1995 1996 1997 1998 1999 2000 2001 2002Govt. Approval,FIPB, SIA 78.36 321.35 1232.18 1674.65 2823.51 2085.94 1473.50 1476.38 2043 1432

RBI approval - 78.63 168.79 180.29 241.70 154.67 181.18 393.83 687 803

NRI Schemesoperated by RBI 65.64 182.70 627.71 599.61 289.93 90.88 83.09 81.19 49 2

GDR/FCCB - - 143.31 478.35 957.90 12.91 1595.40 1626.51 527 636Inflow on transferof shares fromresident tonon-resident - - - 88.40 265.96 1027.53 465.22 665.22 628 1083

Sub-Total 144.00 582.67 2172.00 3021.29 4579.00 3371.94 3798.39 4056.73 3934 3956

Advancepending issueof shares underFIPB/SIA/RBI approval - - - - - - 215.94 445.27 149.8 406.8

Total 144 583 2172 3021 4579 3377 4016 4502 4083.8 4362.8

Notes:Special NRI Schemes were administered by RBI from 1 st January 1991Source: Secretariat of Industrial Assistance Newsletter, various issues. January 2001, Ministry of Commerce and Industry,Government of India.

8/2/2019 CR_indAB

20/68


industries accounted for about 70 percent of the approved FDI amount,signifying that FDI inflow has remained confined/concentrated within afew industrial sectors.

Table 7 shows the sectoral distribution of FDI. Until the early 1990s, FDIwas heavily concentrated in manufacturing.

Following 1991 liberalisation programme, however, there has been a sharprise in approved foreign investment in tertiary sector that encompasses

critical elements of the modern economy namely Information Technology(IT) sector (comprising telecommunications, computer software, consultingservices, etc), power generation and hotel & tourism.

Increased FDI flows to service sector and power generation is a welcomedevelopment because these areas had long been reserved for the publicsector enterprises which were inefficient in managing these services,making Indias trade and industrial sector least competitive in internationalcontext. The share of service sector rose significantly from one percentin 1992-93 to about 12 percent in 2000-01.

1.3.2. Cross-border Mergers & AcquisitionsCross-border mergers and acquisitions (M&As) has been a very importantfeature of inward FDI flow into India over the 1990s. Table 8 shows therelative importance of the various categories of cross-border M&As inIndia between 1991-1998. FDI, involving financial inflow of over US$3691mn,financed cross-border M&A activity, either through acquisition ofsubstantial equity stakes in existing ventures or through buy-out of realassets through asset sales.

Among the categories of cross-border M&As shown in Table 8, the mostimportant in the early part of the 1990s was investment by foreign parentsin erstwhile Foreign Controlled Rupee Companies (FCRC) to raise theirequity stake after the relaxation of restrictions on foreign equity investmentimposed by FERA.

Increased FDI flows to service sectorand power generation is a welcome

development because these areashad long been reserved for the

public sector enterprises whichwere inefficient in managing these

services.

Table 7: Sectoral Distribution of Foreign Direct Investment (as a percentage of total)Sector/Industry 92-93 93-94 94-95 95-96 96-97 97-98 98-99 99-00 00-01

Chemicals & Allied

Products 17 18 16 9 15 9 19 8 7

Engineering 25 8 15 18 35 20 21 21 14

Domestic Appliances 6 1 12 0 1 2 0 0 0

Finance 1 10 11 19 11 5 9 1 2

Services 1 5 11 7 1 11 18 7 12

Electronics & Electrical

Equipment 12 14 6 9 7 22 11 11 11

Food & DairyProducts 10 11 7 6 12 4 1 8 4

Computers 3 2 1 4 3 5 5 6 16

Pharmaceuticals 1 12 1 4 2 1 1 3 3

Others 25 19 19 24 14 22 13 35 30

Total 100 100 100 100 100 100 100 100 100

Source: RBI Annual Reports, various issues

8/2/2019 CR_indAB

21/68


1.3.3. Technology CollaborationsA sectoral break-up of FDI inflow in India showed (as discussed earlier)that a large part of FDI inflow came into medium or low technologyindustries, in which case the positive externality arising from technologyspillovers would also be limited. A liberal FDI regime might also weakenthe bargaining position of domestic firms in the international technologylicensing market, as foreign firms make equity participation a preconditionfor technology transfers.

Data for India actually shows a very sharp increase in the share oftechnology-cum-financial collaborations approved in total foreigntechnology collaboration approvals (which includes foreign technologycollaborations with or without financial collaboration) from 1991 to 2000(see Table 9).

Table 8: FDI Inflow & Cross-border Acquisitions in India, 1991-December 1998

Category Number Amount Amount as percent-

of Cases (US$mn) age of Total FDI

Inflows and Acquisitions

Erstwhile FCRC companies1 80 407.72 11.0

To increase stake in Joint Ventures2 123 1279.53 34.7

To acquire stake in Indian company3 155 1379.15 37.4

Strategic alliance or portfolio investment4 85 448.95 12.2

Asset Sale5 15 176.15 4.8

Total 458 3691.50 100

1 Denotes cases where FDI inflow financed rise in equity stake of foreign parents in their Indian subsidiaries,or the erstwhile FCRC.

2 Denotes cases where FDI inflow financed rise in equity stakes of foreign partners in their existing jointventures with Indian promoter groups.

3 Denotes cases where FDI inflow financed acquisition of equity stake by foreign companies in Indian firms,where they did not have any previous equity participation.

4 Denotes cases where FDI inflow financed acquisition of minority stake (less than 26 percent) by foreignfirms in Indian companies.

5 Denotes cases of asset sales (like brands or manufacturing assets) by Indian companies to foreign controlledfirms.

Source:Saha 2001.

Table 9: Number of Technical and Technical-cum-Financial Foreign Collaborations in India

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

1.Technical collaborations 661 828 691 792 982 744 660 595 498 418

2.Technical-cum-financial

collaborations 289 692 785 1062 1355 1559 1665 1191 1726 1726

3.Total foreign collaborations 950 1520 1476 1854 2337 2303 2325 1786 2224 2144Source: SIA Newsletter, October 2001, Ministry of Industry, Government of India

8/2/2019 CR_indAB

22/68


1.4. Balance of Payments: Capital and Current Accounts

Table 10 shows the overall balance of payments data and composition ofthe total capital account in India over the 1990s. Average foreign investmentinflows between 1993-2001 were more than 20 times the average levelsbetween 1985-1991.

This sharp increase in the level of foreign investment flows, however, didnot lead to an equally sharp increase in the total capital account surplus(i.e. net capital account inflows), because of offsetting declines in othercomponents of the capital account, particularly in net aid flows and netNRI Deposits5.

The increase in foreign investment inflows nonetheless led to a change inthe composition of the capital account, with foreign investment becominga more important component of the capital account in the 1990s.

1.4.1. Foreign Exchange Rate

The RBI, over the period 1993/94-2000/01, intervened aggressively in theforeign exchange market as a net buyer of foreign exchange which hadthe effect of resisting the upward pressure on the exchange rate of theRupee.

Table 10: Indias Overall Balance of Payments (in US$mn)

91-92 92-93 93-94 94-95 95-96 96-97 97-98 98-99 99-00 00-01

Current AccountDeficit 1178 3526 1158 2701 5910 4619 5500 4038 4698 2579

Capital AccountExternal Assistance,

net 3037 1859 1901 1434 883 1109 907 820 901 427

CommercialBorrowing, net 1456 -358 607 1029 1275 2848 3999 4362 313 4011

Short term credit,net -515 -1079 -769 330 49 838 -96 -748 377 105

NRI Deposits, net 290 2001 1205 847 1103 3350 1125 1742 1540 2317

Foreign Investment,net 139 555 4235 4895 4805 6153 5390 2412 5191 5102

Rupee debt service -1240 -878 -1053 -1050 -952 -727 -767 -802 -711 -617

Other capital, net 801 866 3709 1321 -3074 -1565 -714 779 2833 -2322

Total capital account 3968 2966 9835 8806 4089 12006 9844 8565 10444 9023Overall Balance 2790 -560 8677 6105 -1221 6793 4511 4222 6402 5856

IMF, net 786 1288 187 -1146 -1715 -975 -618 -393 -260 -26

Reserves andmonetary gold(increase -,decrease +) -3576 -728 -8864 -4959 2936 -5818 -3893 -3829 -6142 -5830

Foreign investmentas % of total capitalaccount surplus 3.5 18.7 43.1 55.6 117.5 51.2 54.8 28.2 49.7 56.54

Source:RBI Annual Reports, 1995-96 (for 1991-95) and 1998-99, for the rest.

Sharp increase in the level offoreign investment flows, however,

did not lead to an equally sharpincrease in the total capital

account surplus (i.e. net capital

account inflows), because ofoffsetting declines in othercomponents of the capital account,

particularly in net aid flows andnet NRI Deposits.

8/2/2019 CR_indAB

23/68


Table 11 shows the nominal exchange rate of the Rupee against the USDollar at end-March of each year during this period. As the figuresindicate, RBI successfully prevented any nominal appreciation of the Rupeewith respect to all major currencies. Over this period, it in fact, allowed adepreciation of the domestic currency to the extent of about 48 percent

in nominal terms, with respect to the US Dollar.However, in terms of the REER (Real Effective Exchange Rate), basedon the 36-country trade-weighted series published by the RBI6, the Rupeeshows an appreciation of 12 percent between 1993-2001. If we look into

the foreign exchange reserves of the RBI, between March 1993, andMarch 2001, it shows an accretion to the tune of about US$32bn.

1.4.2. Savings and Investment Rates

Table 12 gives gross domestic savings and investment rates as alsotrade and current account7 deficits, as a percentage of GDP at currentmarket prices, that the economy has been running over the recent years.

The figures show that between 1992-93 and 2000-01, the economy hasbeen running, on an average, a current account deficit of only 1.1 percentof GDP, which is slightly lower than the current deficit in the early 1980s(1.3 percent of GDP) and substantially lower than that in the second

half of 1980s (2.2 percent of GDP).

The average current account deficit during 1991-2001 was around 1.04percent of GDP at current market prices, much lower than the averagefor the second half of the 1980s, i.e. 2.2 percent of GDP. Therefore, itimplies that in spite of larger foreign capital inflows in the 1990s, foreignfinancial inflows hardly played any significant role in augmenting domesticinvestment rates.

Table 11: Exchange Rate of Rupee & Foreign Exchange Reserves of RBI.1

1993 1994 1995 1996 1997 1998 1999 2000 2001

Nominal exchangerate r2

Rs./US$ 31.5 31.4 31.44 34.35 35.9 39.5 42.43 43.62 46.64

Annual % change in r(- implies depreciation) _ 0.32 -0.13 -9.2 -4.5 -10.03 -7.42 -2.8 -6.9

REER3 59.15 63.55 63.2 61.92 65.87 66.04 68.33 63.30 66.46

Reserves4 9.8 19.25 25.19 21.70 26.42 29.38 32.49 38.04 42.28

Changes in reserves5 0.6 9.45 5.94 -3.49 4.72 2.96 3.11 5.55 4.24

1 All data relate to March-end figures for corresponding years2 Nominal exchange rate of the Rupee in terms of 1 US$; RBI Reference Rate3 36-country trade weighted Real Effective Exchange Rate published by RBI. Base 1985=100; a decrease in REER implies

a real depreciation of the Rupee4 Foreign exchange reserves of RBI, in billions of US dollars5 Change in foreign exchange reserves of RBI, over last year (in US$bn )

Source: RBI Annual Reports, various issues

In spite of larger foreign capitalinflows in the 1990s, foreign

financial inflows hardly played anysignificant role in augmenting

domestic investment rates.

8/2/2019 CR_indAB

24/68


Table 12: Savings, Investment Rates, Current Account (CAD) & Trade Deficit (TD);as Percentage of GDP in Current Prices

85-901 90-91 91-92 92-93 93-94 94-95 95-96 96-97 97-98 98-99 2 99-00 00-01

GrossDomestic

Savings 20.6 24.3 22.8 22.1 22.5 25 25.5 23.3 24.7 22.3 22.3 -GrossDomesticInvestment 23.1 27.7 23.4 24 23.1 26.1 27.2 24.6 26.2 23.4 23.3 -

CAD 2.2 3.2 0.5 1.5 0.5 1.1 1.8 1.2 1.3 1.0 1.0 0.5

TD 3.2 3.2 1.0 2.0 0.5 1.4 3.1 3.7 3.7 3.2 4 3

1Provisional Figures. Figures from 1996-97 onwards are based on the new series of GDP estimates being calculated from1994-95, which gives a higher estimate of GDP compared to the old series.

Notes:1. Difference between gross domestic savings and investment rates do not equal current deficit due to rounding off.2. CAD and TD figures for 1980s and 1990s are not strictly comparable, as the 1990s figures are reported according to the

revised format suggested by the High Level Committee (constituted in November, 1991) on Balance of Payments, headed byDr.C.Rangarajan. The trade deficit figures for the 1990s includes gold brought in by NRIs with baggage, with a contra entryin private transfers, and some non-customs defence related imports funded through bilateral debts. Therefore, TD and CADin the 1990s has an upward bias compared to the figures for the 1980s. (RBI Bulletin, August 1993, pp.1139-1180)

Source:RBI Annual Reports; Economic Survey, Ministry of Finance, Government of India, various issues.

Issues for Comments

l Domestic firms are at a comparative disadvantage due to highcost of capital as against foreign firms headquartered in economieswith lower interest rates. What steps do we need to take torestructure the real interest rates for attaining equilibrium in interestrates between domestic and foreign competitors? Why FDI inflowsin India remain concentrated within a few industrial sectors?

l In spite of liberalising capital controls in 1991, why is India notreceiving FDI flows commensurate with the size of the economy?

l What might be the factors behind lower actual FDI flows againsthigher approved FDI flows?

l In India there is sharp increase in the share of technology-cum-financial collaborations in total foreign technology collaborationapprovals. Is it good for the economy?

l Has the policy of maintaining a large foreign exchange reserveresulted in marginalising the role of foreign financial inflows inaugmenting domestic investment rates?

l Does FDI in India serve as an engine of growth?

8/2/2019 CR_indAB

25/68


CHAPTER-II

Overview of Main Policy Trends

2.1. Economic Reforms in IndiaThe economic reformsor economic liberalisation programme wasimplemented with the announcement of the New Economic Policy (NEP)in 1991. It included wide-ranging changes in industrial policy, trade policyand foreign investment policy, a redefinition of the role of the public sectorin the economy and a redesigning of the architecture of the domesticfinancial system. These radical policy changes were, however, notstrategy-driven8. It was more a crisis-driven response.

2.1.1. Background

Between late 1990 and the middle of 1991, the economy faced severebalance of payments difficulties, coming close to defaulting on its externalpayment obligations in January and June of 1991. In January 1991, theGovernment accessed the Compensatory and Contingency FinancingFacility of the International Monetary Fund (IMF) and in June 1991negotiations were initiated for loans under SBA (Stand-by Arrangement)lending facility of the IMF.

What followed was the implementation of the conventional IMF-WorldBank prescription of short-term stabilisation, consisting of devaluation,temporary import compression, fiscal and monetary compression with arise in interest rates. This was followed by more long-term structural

adjustment measures, seeking to restructure the domestic economy.The New Economic Policywas an outcome of implementation of thestructural adjustment programme9.

2.1.2. Domestic OpinionThough the initiation of the economic reform program was crisis-driven,it is also true that domestic opinion favouring a more liberal economicpolicy environment was building up over the 1980s. Concerns about inwardlooking trade regime, public sector inefficiencies and a restrictive industriallicense policy (the license-permit Raj, in popular parlance) were beingraised generating a debate and rethinking on the development policy ofthe country10.

2.1.3. Changes in Industrial PolicyThe main industrial policy changes, brought in trail of NEP, were as follows:l Industrial licensing system was abolished except for a very short list

of 18 industries (Appendix II of Statement on Industrial Policy, 1991),where compulsory licensing was retained. In many sectors within these18 industries (like white goods and entertainment electronics), licensingwas discontinued from 1993.

l The Monopolies and Restrictive Trade Practices (MRTP) Act 1969was amended to abolish pre-investment scrutiny of the investmentdecisions of the MRTP companies(large firms with assets higherthan the threshold limit as declared in the Act from time to time) and

The implementation of the

conventional IMF-World Bankprescription of short-term

stabilisation, consisting ofdevaluation, temporary import

compression, fiscal and monetarycompression with a rise in interestrates, was followed by more long-

term structural adjustmentmeasures, seeking to restructurethe domestic economy. The New

Economic Policy was an outcome ofimplementation of the structural

adjustment programme.

Though the initiation of theeconomic reform program was

crisis-driven, it is also true thatdomestic opinion favouring a more

liberal economic policyenvironment was building up over

the 1980s.

8/2/2019 CR_indAB

26/68


to obtain prior approval of central government for expansion,establishment of new undertakings, mergers, amalgamations andtakeover of other firms by firms that came under the purview of MRTPAct. Though the MRTP Act was diluted, a new competition law hasnot yet been put in place.

l The list of industries reserved for the public sector was reduced from

17 to 6. Privatisation of state-owned enterprises (SOEs) has, however,been very slow and the government has not been able to meet itstargets for divestment of government stake in SOEs. Unlike in manyother developing economies, particularly in Latin America and EasternEurope, FDI inflow into India has not been driven by privatisation andsale of SOEs to foreign investors.

l Norms for foreign technological and financial collaboration wereconsiderably liberalised and foreign firms were allowed greater freedomto enter and operate in the economy.

2.1.4. Financial Liberalisation

Financial liberalisation has been the other important cornerstone of theeconomic reform programme. It followed the well-known path of deregulationof capital markets and banks, deregulation of interest rates, withdrawalof credit targeting and interest subsidies, introduction of stricter accountingnorms in the banking sector (following the Basle Standards) and integrationof domestic financial markets with the global financial system throughliberalised capital control measures to allow greater freedom for cross-border capital flows. All this, again, can be expected to have effects onthe domestic industry by affecting costs and availability of capital.

2.2. Membership in International and Regional Trade Arrangements

India has been a member of the WTO since its inception in 1995. Certainpolicies of trade liberalisation have been driven by WTO conditionalities,the most recent being the removal of Quantitative Restrictions on importsby April 2001 after India lost a dispute at the WTO with the USA11.

The industrial policy changes, particularly the discontinuance of thelicensing system permitted business firms to pursue their own investmentand expansion strategies without being restricted by the licensingrequirements. However, simultaneous lowering of trade barriers andliberalisation of foreign investment regime, allowing foreign firms to enterand operate in the domestic economy, exposed domestic firms tosignificant foreign competition.

India, as a member of the SAARC, is also part of SAPTA (Agreement on

SAARC Preferential Trade Arrangement). However, there has been littleprogress in dismantling trade barriers among the member countries asyet, though India has made a start in reducing barriers bilaterally withNepal, Sri-Lanka and vis-a-vis Pakistan.

2.3. Capital Controls: Capital Account Liberalisation

2.3.1. GDR/ADR issues by domestic firmsIndian companies were allowed to raise capital in overseas markets byissuing Global Depository Receipts (GDRs), American DepositoryReceipts (ADRs) and Foreign Currency Convertible Bonds (FCCB) from1992.

Financial liberalisation has beenthe other important cornerstone of

the economic reform programme. Itfollowed the well-known path of

deregulation to allow greaterfreedom for cross-border capital

flows.

The industrial policy changes,permitted business firms to pursue

their own investment and expansionstrategies without being restricted

by the licensing requirements.However, simultaneous lowering of

trade barriers and liberalisation offoreign investment regime, exposed

domestic firms to significantforeign competition.

8/2/2019 CR_indAB

27/68


The first Indian GDR issue (by Reliance Industries) was made in May1992. There were no limits to the amount that could be raised throughGDR issues, but only companies having a good track record (for threeconsecutive years prior to the issue) were given permission to accessthe GDR market12. The funds raised through GDR issues could be utilisedin any manner, except that such funds could not be invested in the stock

market and used for real estate investments.

The end-use restrictions began to be enforced from September 1994.Inflows through GDR issues are considered by the Ministry of Industryas part of FDI inflow and are, hence, subject to the limits/sectoral capsaccording to the FDI policy. GDR issues, not falling within the automaticFDI approval category, therefore, have to seek FIPB approval prior to theissue13.

Indian companies were also permitted to raise debt from the internationalmarket through External Commercial Borrowings (ECBs). Debt issues,however, were more regulated with the necessary precondition of priorRBI permission14. RBI set overall limits on the level of aggregate ECBs

and borrowings beyond that stipulated limit were not allowed.

2.3.2. Other Capital Account Liberalisation Measures

Though capital controls were considerably liberalised for inflows of foreigncapital, either in the form of direct investment or portfolio investment,restrictions continued to exist for outflows on the capital account,especially for domestic residents, the domestic non-banking corporatesector and the banking sector. The norms for outward FDI by Indiancompanies were also much more stringent than inward investment rules.The limits and conditions under which Indian companies could investabroad (outward FDI) are discussed below (Guidelines, as existing inMay 2001).

1. Less than 25 percent of the annual average export/foreign exchangeearnings of the Indian firm in the preceding three years.

2. Funded out of GDR proceeds (upto 100 percent of GDR issue) or outof Export Earners Foreign Currency (EEFC) Account balances uptoUS$15mn16.

Indian companies investing in Wholly Owned Subsidiaries (WOS) andJoint Ventures (JVs) abroad are given automatic approval by RBI, if theamount of investment is less than US$30mn for SAARC countries,US$15mn15 for elsewhere and US$25mn for Nepal and Bhutan for aperiod of three years.

2.3.3. Outward FDI: Automatic Approval

Automatic approval is subject to the condition that the full amount of theinvestment17 has to be repatriated by way of dividends, royalty, technicalfees etc. within a period of 5 years from the date of first remittance ofequity to the foreign concern. Only one such automatic approval (for asingle proposal) is provided for a company within a block of three years.(Government of India, 1999)

The investment norms were liberalised further in 1999-2000 by raisingthe limit for automatic approval for outward FDI to US$50mn (instead ofUS$15mn, as indicated above) and further on in 2000-2001, to US$ 50mn

Indian companies were alsopermitted to raise debt from the

international market throughExternal Commercial Borrowings(ECBs). Reserve Bank of India set

overall limits on the level ofaggregate ECBs and borrowings

beyond that stipulated limit werenot allowed.

The investment norms wereliberalised further in 1999-2000 and

then in 2000-2001 by raising thelimit for automatic approval for

outward FDI.

8/2/2019 CR_indAB

28/68


every year (instead of every three years). The limit for external investmentby computer software companies with export/ foreign exchange earningswas raised to a higher level of US$100mn in a block of three years18 .

2.3.4. Outward FDI: Case-by-case Approvals

Investments not eligible for automatic approval are approved on a case-by-case basis. The RBI notification states that investments beyond

US$15mn (revised to US$50mn from 1999-2000) can be approved only inexceptional circumstances, where the company has a strong track recordof exports or where other compelling benefits exist for the Indian company(Government of India, 1999).

The outward FDI regime is, therefore, much more stringent than the inwardFDI regime. The clause subjecting Indian overseas investment to fullrepatriation of the invested amount within 5 years, by way of dividend,technical fee etc., is particularly restrictive. It precludes aggressiveinvestment behaviour by Indian companies in overseas markets as theyare under pressure to generate profits within a short period of investing inoverseas markets.

2.3.5. Trade Liberalisation

Apart from the domestic corporate sector, capital controls were liberalisedfor other domestic economic agents as well, but very cautiously mostlythrough the second half of 1990s. Exporters were permitted to retaintheir export earnings abroad for upto 180 days before repatriating it.Exporters and importers were also allowed to take forward cover for theirtrade-related transactions (either forward sale or purchase of foreignexchange) in the foreign exchange market, on the basis of businessprojections and documents substantiating the trade-related transaction.

Though trade-related transactions continue to be the basis of exporters'/importers participation in the foreign exchange market, the limited freedomallowed does enable them to take positions with respect to their foreigncurrency exposure, depending on their expectations (or speculations)about movements of the domestic currency. This also established a linkbetween the current and capital accounts.

2.3.6. Liberalisation in the Banking Sector

The domestic banking sector was allowed limited freedom on its capitalaccount transactions. Banks could borrow or invest up to 15 percent oftheir Tier I capital abroad. They were allowed to engage in swaptransactions19 in the foreign exchange market without seeking prior RBIapproval.

Banks could also maintain open positions20 with respect to their foreigncurrency exposure, within limits (called gap limits) specified by the RBIfor each bank. This limited freedom allowed to banks enabled them toengage in arbitraging between the domestic money market and foreignexchange market, thus, forging links between two segments of the financialsystem21 .

Exporters, importers and domestic commercial banks thus participatedin the foreign exchange market, their transactions being guided, at leastin part, by speculation motives and driven by expectations about movementof the exchange rate of domestic currency.

The outward FDI regime is,therefore, much more stringent

than the inward FDI regime.Itprecludes aggressive investment

behaviour by Indian companies inoverseas markets as they are underpressure to generate profits within

a short period of investing inoverseas markets.

The domestic banking sector wasallowed limited freedom on its

capital account transactions.Exporters, importers and domesticcommercial banks participated in

the foreign exchange market.

8/2/2019 CR_indAB

29/68


2.3.7. Foreign Institutional Investors (FIIs)Since 1991, Government of India has undertaken several steps to liberalisethe norms for FII in the country (see Table 13).

Approved categories of FIIs were allowed to engage in purchase andtrading of securities in the country and were given full rights to repatriatetheir capital and income/profits. Total FII (along with NRI investments)22

was limited to 24 percent of paid-up capital of a company, with anadditional limit of 5 percent (raised to 10 percent through an amendment

on October 9, 1996) on the investment made by a single FII sub-account.In 1996, two changes raised the limit on total FII in a company. Firstly,by separating FII and NRI investments and making the limit on FII alone24 percent, and secondly, by allowing FII up to 30 percent in companieswhich obtained shareholders' permission to allow the enhanced level ofFII. 23

With the passage of the SEBI (FII) Regulations Act, 1995, regulationsgoverning FII investments, which were initially under administrative jurisdiction of RBI and Ministry of Finance, were brought under thejurisdiction of the independent stock-market regulator, SEBI in 1995. Theregulations were amended a number of times over the 1990s, allowinggreater freedom to FIIs for their operations (SEBI, 1995).

Table 13: Significant Regulatory Changes Involving FII in India over 1990s

Date Regulatory change

14 September, 1992 RBI notification permitting FII in Indian securities.

December 1993 FIIs allowed to invest in the new schemes of mutual funds

May 1994 Companies allowed to issue preferential equity to FIIs14 November, 1995 Securities and Exchange Board of India (SEBI) (FII) Regulations, 1995 introduced;

SEBI levies a registration fee of US$10,000 per sub-account of an FII for registeringas an approved FII for a period of 5 years.

9 October, 1996 The category of eligible FIIs expanded to include university funds, endowments,foundations or charitable trusts or charitable societies. FIIs were also allowed toinvest in warrants of unlisted firms.

19 November 1996 FIIs are permitted to invest upto 100 percent of funds of dedicated debt sub-accounts in debt securities. Previously only 30 percent of the total investmentcould be put into debt instruments.

20 April, 1998 FIIs are allowed to invest in dated Government securities; also allowed to lendsecurities through approved intermediaries.

18 May, 1998 FIIs are allowed to invest in Treasury Bills.

30 June, 1998 FIIs are allowed to invest in derivatives listed in recognised stock exchanges;also allowed to invest in unlisted debt securities.

31 March, 1999 FIIs are allowed forward foreign exchange cover on their investments (full amount)remitted after 31 March 1999. The total amount of outstanding investments thatcan be hedged, however, was limited to 15 percent on outstanding investmentsof an FII and an additional 15 percent, on a case by case basis after RBI approval.

6 April, 1999 FIIs are allowed to participate in open offers in accordance with SEBI Takeover

Code, 1997.Source:SEBI (1995), and newspaper reports retrieved from VANS, various dates

8/2/2019 CR_indAB

30/68


2.3.8. Fiscal Regime forFIIs

Initially, FIIs were given favourable tax treatment compared to Indianinvestors with respect to taxation of dividend income and capital gainsarising from their trading in securities. The favourable tax treatmentprevailed right from the announcement of the entry norms for the FIIs.They were taxed at 20 percent on income received from securities, 10percent on long-term capital gains24 and 30 percent on short-term capital

gains realised from trading of securities.

In contrast, the tax rate on long-term capital gains was 46 percent fordomestic companies (23 percent for venture capital funds) and that onshort-term capital gains was 51.75 percent for widely held domesticcompanies and 57.5 percent for closely held domestic companies. Therates on investment income were the same as the ones on short-termcapital gains. The FIIs tax rates were also lower than those applicablefor NRI investments. Many of these asymmetries were eventuallyaddressed, by lowering the tax rates for domestic companies and NRIinvestors to bring them at par with the rates applicable to FIIs in 1996-97(VANS, various dates).

FIIs were given favourable taxtreatment compared to Indian

investors. Many of theseasymmetries were eventually

addressed, by lowering the taxrates for domestic companies andNRI investors to bring them at parwith the rates applicable to FIIs in

1996-97

Issues for Comments

l Were the 1991 economic reforms a strategy-driven choice or acrisis-driven response?

l Does a mechanism exist ensuring positive externalities of foreigninvestment along with FDI flows?

l Would financial liberalisation reduce the cost and availability offinance to the domestic industry?

l Would the liberalisation of norms for outward FDI flow for computersoftware companies benefit the same?

l Is the impact of liberalisation of banking sector postive on foreignexchange market and should the banks be allowed more freedomon their capital account transactions?

l Are domestic investors now on a level playing field vis--vis ForeignInstitutional Investors with respect to taxation of dividend incomeand capital gains arising from their trading activation in securities?

8/2/2019 CR_indAB

31/68


CHAPTER-3

Investment Policy Audit

3.1. Liberalisation of Inward Foreign Direct Investment Policies

Very few industries are actually out of bounds for FDI under the presentpolicy. Defence and strategic industries, agriculture (including plantation),and broadcasting are some of the few sectors where FDI is not allowed.In some sectors like insurance, FDI upto 26 percent foreign equityparticipation has been allowed only recently. In other sectors, liketelecommunications services (paging, cellular and basic services), directFDI participation is allowed to the extent of 49 percent of the paid-upcapital of licensees.

Therefore, under the current policy regime, there are, for foreign direct

investors, three broad categories of industries. In a few industries, FDI isnot allowed at all; in another small category, foreign investment is permittedonly till a specified level of foreign equity participation; and finally a thirdcategory, comprising the overwhelming bulk of industrial sectors, whereforeign investment upto 100 percent equity participation by the foreigninvestor is allowed. The third category has two subsets one subsetconsisting of sectors where automatic approval is granted for foreign directinvestment (often foreign equity participation less than 100 percent ) andthe other consisting of sectors where prior approval from the FIPB isrequired.

3.2. Entry and Establishment

Currently, foreign investors are allowed to set up a liaison office,representative office or wholly or partially owned subsidiary (or joint venture)in India. Here we discuss the entry restrictions and the changes in theregulations governing FDI (defined to include all investment where foreigninvestor owns greater than 10 percent of the paid-up capital of a companyregistered in India).

The Statement on Industrial Policy(Government of India, 1991), madeFDI in 34 industries (listed in Annex III of Statement on Industrial Policy,1991) eligible for automatic approval upto a foreign equity participationlevel of 51 percent of the paid-up capital of a company. The automaticapproval was, however, conditional on the requirement that capital goods

import be financed out of foreign equity inflow and dividend repatriation bebalanced by export earnings over a period of time (though the time periodwas not stated in the Policy Statement; these restrictions, moreoverwere further liberalised subsequently).

The new policy (announced in 1991) was far more liberal in comparisonwith the then existing Act, FERA, that limited foreign equity participationto a maximum of 40 percent, except in very few special cases. (Chaudhuri,1977) The policy revision, therefore, was more important in terms of thechange in the level of control allowed to foreign firms over their Indianoperations.

Under the current policy regime,there are, for FDI, three broad

categories of industries. In a fewindustries, FDI is not allowed at all;

in another small category, FDI ispermitted only till a specified level

of foreign equity participation; andfinally a third category, comprising

the overwhelming bulk ofindustrial sectors, where FDI upto

100 percent equity participation isallowed.

The Statement on Industrial Policymade FDI in 34 industries eligible

for automatic approval upto aforeign equity participation level

of 51 percent of the paid-up capitalof a company.

8/2/2019 CR_indAB

32/68


The FDI policy has undergone a number of changes over the 1990s, witha further expansion of the list of industries eligible for automatic approvalupto 51 percent foreign equity participation and a general movementtowards further liberalisation of the foreign investment regime. Withoutgoing into an enumeration of these changes, we are studying in somewhatgreater detail the policy regime governing foreign investment, as it existedin August 200125.

3.3. Registration ProcedureForeign investors setting up operations in India have to register themselveswith the Registrar of Companies (just like domestic investors). Tax holidaysand other such special incentives are available for investment in certainsectors (like infrastructure projects), but these policies are sector specificand also apply to domestic investment in the relevant sectors. Incentiveshave been rule-based to a large extent (the most important incentive wasperhaps the grant of guaranteed return at excessive levels to the fasttrack power projects promoted by foreign investors in the early 1990s;such policies were, however, discontinued after series of protests by civilsociety and litigation in courts).

However, lobbying (both by domestic interests opposed to entry of foreignfirms and by foreign firms willing to invest in the country) has played arole in setting the rules/policies regarding entry of foreign firms. Notableamong them being the intense lobbying that was witnessed when thetelecom or insurance sectors were being opened.

3.3.1. Routes of ApprovalThere are two major procedural routes currently available for approval ofFDI proposals, besides simplified mechanisms with the Secretariat forIndustrial Assistance (SIA).

3.3.1a Automatic Approval

All investment proposals, except those listed below, are eligible forautomatic approval, which is given by the Reserve Bank of India (RBI).Currently, in areas where automatic approval is applicable, investors areeven allowed to make the investment prior to seeking RBI approval withthe statutory requirement that they inform the RBI Department concernedwithin a month of making the investment.

The cases not eligible for automatic approval are

1. Proposals where investment is in Annexure II26 industries, i.e. thoserequiring compulsory industrial licensing. There are 6 industries inAnnexure II, including distillation and brewing of alcoholic drinks,manufacture of cigars and cigarettes, electronic aerospace and defence

equipment, industrial explosives, hazardous chemicals and drugs andpharmaceuticals.

2. Proposals where 24 percent or more foreign equity investment is beingsought to be made in manufacturing units reserved for the small-scalesector (If FDI beyond 24 percent is made in such small scale industry(SSI) units, the unit loses its SSI status. As per the Reservation Policyof SSI, units not falling under the SSI Sector have to take a licenseand export 50 percent of their production for producing items reservedfor SSI Sector) and where FDI falls under the restrictions imposeddue to locational policy of the Industrial Policy.

Foreign investors setting upoperations in India have to register

themselves with the Registrar ofCompanies (just like domestic

investors). Tax holidays and othersuch special incentives are

available for investment in certainsectors (like infrastructure

projects) but these policies aresector specific and also apply to

domestic investment in the relevantsectors as well.

All investment proposals, except afew, are eligible for automatic

approval, which is given by theReserve Bank of India.

8/2/2019 CR_indAB

33/68


3. Proposals with a foreign collaborator who has a previous tie-up/venturein India.

4. Cases that involve acquisition of shares of existing Indian companies(only cases involving transfer of existing shares from residents to non-residents; so cases where foreign investor gets higher equity stakethrough preferential issue of shares by its subsidiary does not come

under this provision).

The Government notifies different lists of industries, through Gazettenotifications, for which automatic approval is to be granted upto 51, 74and 100 percent of foreign equity participation. In 1991, only the list withapproval upto 51 percent was there. The original list of 34 industries wasexpanded to include other industries and new lists of industries, eligiblefor automatic approval for foreign equity participation upto 74 and 100percent, over the 1990s. These lists were also altered a number of timesover the 1990s, to transfer industries in the 51 percent list to the 74 or100 percent list. In general, the direction of change has been towards amore liberal regime.

3.3.1b FIPB Approval

FDI proposals, which do not fall within these notified lists (for automaticapproval) or fall under categories 1-4 above, are required to go throughthe second procedural route. Such proposals are scrutinised by the ForeignInvestment Promotion Board (FIPB) for approval. The FIPB is, in principle,a single window facility made available to foreign investors for seekingapproval. Before each proposal is considered in the FIPB, the commentsand observations (concurrence or opposition) of the relevant administrativeministry/ministries (for instance, a FDI proposal in oil refining would comeunder jurisdiction of the Petroleum Ministry) on the proposal are madeavailable to the FIPB.

The FIPB follows some general guidelines in taking its decisions. Oneimportant guideline relates to proposals where the foreign investor alreadyhas an existing tie-up/joint-venture operating in India or the foreign companywishes to acquire shares in existing Indian companies. In such cases, ano-objection certificate from the Indian partner of the existing venture or aresolution adopted in the Annual General Meeting of the companysshareholders approving the investment by the foreign collaborator isessential to get an FIPB approval.

There are, however, instances where the domestic promoters/majorityshareholders are unwilling to cede or reduce equity control, and thusdomestic companies are provided with protection from hostile take-over

attempts by foreign investors. In general, FIPB approval is granted easilyif the ministries, having administrative jurisdiction over the industryconcerned, do not have any objection to the proposal. In cases wheresuch objection exists, FIPB has to deliberate and arrive at a decision.

In cases where the foreign investment amounts to less than US$130mn,the Ministry of Industry approves the FDI proposal directly on the basis ofthe recommendation of FIPB and in cases where the proposed investmentis greater than US$130mn, the proposals are given final approval by theCabinet Committee on Foreign Investment (CCFI). However, FIPB mayalso refer proposals with investment less than US$130mn to CCFI.

The Foreign Investment PromotionBoard (FIPB) is, in principle, a

single window facility madeavailable to foreign investors for

seeking approval.

FIPB approval is granted easily ifthe ministries, having

administrative jurisdiction over theconcerned industry, do not have

any objection to the proposal. Incases where such objection exists,

FIPB has to deliberate and arrive ata decision.

8/2/2019 CR_indAB

34/68


3.3.1c Simplified Mechanisms

Under the existing Industrial Policy, a short list of only six industries iskept under licensing. All applications for which approval is required fromthe Government, are to be filed with SIA and considered by subject specificCommittees/Boards and decisions are taken in a time bound manner.These Committees include the Project Approval Board (PAB) for foreigntechnology agreement cases; the Board of Approval (BOA) for 100 percent

Export Oriented Units; the Licensing Committee (LC) for industrial licence,the Inter Ministerial Committee for Electronic Software & Electric HardwareTechnology Park Sectors (EHTPs & STPs), Empowered Committee forgranting concessions under the Income Tax Act for Industrial ModelTowns, Industrial Parks, etc.

3.3.2. Special Provisions

In addition to the general policies on FDI, certain special provisions havebeen made for direct investment by NRI and Overseas Corporate Bodies(OCBs), where NRIs hold at least 60 percent equity. For example, NRI/OCBs are allowed to invest upto 100 percent equity in air taxi operationsand civil aviation, where the general limit for FDI is 40 percent27.

NRI investments are also allowed in housing and real estate, where generalforeign investors are not allowed. NRI investment in housing/real estate,however, carries restrictions of a 3-year lock-in period for the investmentand a limit of 16 percent on dividend repatriation. Further, NRI investmentsare allowed in sick industries, for the purpose of their revival.

3.3.3. Requirements for Foreign Technology Collaborations

Along with the liberalisation of FDI rules, norms for foreign technologycollaboration (with or without equity participation of the foreign collaborator),payment of technology fees, royalties on technology, brands or copyrightshave also been made liberal.

Foreign firms, for instance, obtained an automatic right over theirinternational brands in Indian market from 1992 onwards, after theprovision, requiring foreign firms to seek special Government permissionfor using their international brands in the domestic market was revoked.(Recall that when PepsiCo launched sof

CR_indAB

Documents

Transcript of CR_indAB