THEORETICAL FRAMEWORK OF FDI AND POLICY INITIATIVES OF INDIA

Transcription

1 Chapter 2 THEORETICAL FRAMEWORK OF FDI AND POLICY INITIATIVES OF INDIA Foreign Direct Investment (FDI) acquired an important role in the international economy after the Second World War. Theoretical studies on FDI have led to a better understanding of the economic mechanism and the behaviour of economic agents, both at micro and macro level allowing the opening of new areas of study in economic theory. To understand foreign direct investment must first understand the basic motivations that cause a firm to invest abroad rather than export or outsource production to national firms. The purpose of this unit is to identify the main trends in FDI theory and highlight how these theories were developed, the motivations that led to the need for new approaches to enrich economic theory of FDI. Foreign direct investment (FDI) in its classic form is defined as a company from one country making a physical investment into building a factory in another country. It is the establishment of an enterprise by a foreigner. Its definition can be extended to include investments made to acquire lasting interest in enterprises operating outside of the economy of the investor. The FDI relationship consists of a parent enterprise and a foreign affiliate which together form a multinational corporation (MNC). In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. The International Monetary Fund (IMF) defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownership shares are known as portfolio investment. 2.0 Forms of FDI The Forms of FDI include: Purchase of existing assets in a foreign country. New investment in property, plant, equipment. 29

2 Participation in a joint venture with a local partner. Transfer of many types of assets like human resources, systems, technological know-how in exchange and equity in foreign companies. An example, Westin Hotels transferred reservation systems, managers and cost control systems. Export of goods and equity. They method many not be used in the initial stage of the establishment of a company. Through Trading in Equity: Companies also invest in the equity of and foreign companies by purchasing the equity shares of a foreign company. An example, KLM of Netherlands acquired the equity of Northwest Airlines of USA by giving the KLM equity shares to the Northwest Airlines Owners. 2.1 International Investment Theories Neoclassical theory (of international trade and investment) points out that location, timing and mode of investment are inspired by scale and scope advantages through FDI. Beside economies of scale, product differentiation, imperfect competition and trade costs determine the location decision (Krugman, 1991), Krugman, Venables (1994). Barrell and Pain (1999) summarize these determinants as centripetal and centrifugal forces leading to centralization or decentralization of foreign investment. Neoclassical trade theory failed to explain the existence of Multi National Corporations. Explanations in terms of differences in rates of return between countries could explain portfolio investments, but foreign direct investments (FDI). It was not until Hymer presented his work, in 1960, of foreign direct investments and multinational enterprises that a satisfying explanation was at hand. Transaction cost theory explains both the ownership decision and the way of growth decision as a way to minimize transaction costs, due to specific assets (Hennart, 1994). The theory of incomplete contracts and property rights view of the firm shows that a higher share of ownership must be given to the party of the transaction that has the greatest ex-post bargaining power over the division of the surplus. Resource-based theory sees FDI as an attempt to apply under-utilized productive resources to new business opportunities abroad. In organizational learning theory, the establishment mode is determined by the potential firms have to understand knowledge (Barkema, Vermeulen (1998), Hymer (1976)). Finally, the entry mode decision is not taken in isolation. Global 30

3 strategy and global competition plays in determining the appropriate entry mode (Hill, Hwang, Kim, 1990) After all these different attempts to explain why FDI took place and the pioneering work by Hymer (1976), the conceptual framework used until very recently was the one proposed by Dunning (1977), the OLI paradigm. International investment theories include: Ownership Advantage Theory Internationalisation Theory Dunning s Electic Theory Factor Mobility Theory Product Life Cycle Theory Ownership Advantage Theory Caterpillar in order to utilize its technologies and brand name more extensively established its manufacturing facilities in Europe, North America, South America and Asia. And for the same reason, Komastu the rival of Caterpillar also established manufacturing facilities in the USA, Europe and Asia. Similarly Dr. Reddy s Lab started its operations in Europe and South Africa. These companies have the competitive advantage domestically in technology and brand name and established their operations in foreign countries in order to utilize these competitive advantages. Thus, the ownership advantage theory states that the firms having competitive advantage domestically derived from its valuable assets like technology; brand names and large scale economics extend their operations to foreign markets through FDI Internationalisation Theory The ownership advantage theory states that companies with domestic competitive advantage enter foreign markets to utilize their assets. It fails to explain the means of entering foreign markets to exploit the ownership advantages. Internationalisation theory solves this problem. Companies enter foreign markets through various means like licensing, franchising, exporting etc., by entering a contract with foreign firms. The domestic companies have to negotiate, monitor and enforce a contract which involves a transaction cost. 31

4 This theory tries to explain the growth of transnational companies and their motivations for achieving foreign direct investment. The theory was developed by Buckley and Casson, in 1976 and then by Hennart, in 1982 and Casson, in Initially, the theory was launched by Coase in 1937 in a national context and Hymer in 1976 in an international context. In his Doctoral Dissertation, Hymer identified two major determinants of FDI. One was the removal of competition. The other was the advantages which some firms possess in a particular activity (Hymer, 1976). Buckley and Casson, who founded the theory, demonstrates that transnational companies are organizing their internal activities so as to develop specific advantages which then to be exploited. Internalisation theory is considered very important also by Dunning who uses it in the eclectic theory but also argues that this explains only part of FDI flows. Hennart (1982) develops the idea of Internationalisation by developing models between the two types of integration: vertical and horizontal. Hymer is the author of the concept of firm-specific advantages and demonstrates that FDI takes place only if the benefits of exploiting firm-specific advantages outweigh the relative costs of the operations abroad. According to Hymer (1976) the MNE appears due to the market imperfections that led to a divergence from perfect competition in the final product market. Hymer has discussed the problem of information costs for foreign firms respected to local firms, different treatment of governments, currency risk (Eden and Miller, 2004). The result meant the same conclusion: transnational companies face some adjustment costs when the investments are made abroad. Hymer recognized that FDI is a firm-level strategy decision rather than a capital-market financial decision. Internalization theory states that the domestic company enters a foreign market through FDI when the cost of transaction with a foreign firm by high. The domestic company under these conditions internalizes its production, marketing and other operations in foreign markets through FDI. Toyota could not shift its competitive advantages viz., high quality and sophisticated manufacturing techniques through franchising or licensing to a foreign firm as it involves high cost of transaction. Therefore, Toyota internalized its US operations through FDI. In contrast Mc Donald 32

5 and Federal Express entered foreign markets though franchising as they could shift their competitive advantages including brand names to their franchises in foreign countries Dunning s Eclectic Theory Internalization theory fails to explain the reason and locate manufacturing facilities in a foreign country. In fact, companies locate their manufacturing facilities in a foreign country when there is location advantage. John Dunning incorporates location advantage in addition to ownership advantage and internalization advantage in his Eclectic Theory of FDI. This theory states that FDI reflects both international business activity and business activity internal to the firm. According to Dunning location specific advantages are derived by combining the advantages of country location like assets, mineral, human and other resources with the specific advantages of the firm like technology, technical know how, management, marketing capabilities etc. According to him companies go to get the competitive advantages by consuming resource endowments of the host country and unique strengths of the company. An example, Electrolux established its plant in China to take the advantage of low cost labour. Illustration 2.1 Dunning s Eclectic Theory Location Advantage: Location specific factors. These are external to the firm including factor endowment, transportation cost, government regulation, and infrastructure factors. Ownership Advantage: Firm specific factors including: technology, patent, process, name recognition, and other core competencies. OLI Internationalization: Cost advantage from vertical and horizontal integration, due to transaction cost caused by market failure FDI will occur when the three conditions are satisfied. They are: ownership advantage, location advantage and internalization advantage. (Refer Illustration 2.1) Ownership Advantage: The ownership advantages include brand name, technology and large scale economies. The firm should have the competitive advantage in ownership to compete in the foreign markets. Caterpillar has the 33

6 advantage to compete against the local companies in Brazil. Coca-Cola has the advantage to compete against soft drink companies in India. Location Advantage: Locating manufacturing facilities in a foreign country should be advantageous than operating from the domestic country. US Software companies enjoy lower labour costs by locating in India. Japanese automobile companies avoid high import tariffs by locating their manufacturing facilities in the USA. Internalization Advantage: As explained earlier it is advantageous to a domestic company to go with FDI when cost of monitoring, enforcing a contract is costly and practically difficult Factor Mobility Theory Factor endowments including capital vary among countries. Some countries are rich in capital whereas other countries suffer from the problem of paucity of capital. There would be pressures and capital flow from those countries where it is available abundantly to the other countries. The return on capital would normally be less in capital abundant countries and more in capital scarcity countries. The return on capital normally flows from those countries where the return on capital by low to those countries where the return on capital by high. Capital mobility through direct investment often stimulates trade because of the need and the components, complementary products and equipment and subsidiaries. In addition, FDI enhances exports Product Life Cycle Theory Raymond Vernon s product life cycle theory explains the pattern of FDI over time. According to Vernon s, the firms originally developed the product to establish manufacturing facilities to produce the product in foreign countries. Xerox originally introduced photocopier in the USA. It later spread the manufacturing facilities in Japan, Great Britain and India. According to Vernon, firms establish manufacturing facilities in foreign countries, when the product reaches maturity stage in the home country. They invest in low cost countries when cost becomes a competitive edge. 34

7 Vernon believes that there are four stages of production cycle: innovation, growth, maturity and decline. According to Vernon, in the first stage the U.S. transnational companies create new innovative products for local consumption and export the surplus in order to serve also the foreign markets. According to the theory of the production cycle, after the Second World War in Europe has increased demand for manufactured products like those produced in USA. Thus, American firms began to export, having the advantage of technology on international competitors. Production moves from one country to another during the different stages of product life cycle. Production takes place in industrial countries during the introductory stage. Production moves to other industrial countries during the growth stage. Thus, producer invests in various industrial countries during this stage. Production moves to developing countries during maturity stage. In other words, the producer invests in manufacturing facilities in developing counties during this stage, thus, capital moves to other industrialized countries during growth stage and to developing countries during the maturity stage of the product life cycle. 2.2 Factors Influencing FDI Factors influencing FDI are of three categories viz., Supply Factors Firms invest capital in foreign countries due to lower costs of business in foreign countries. These include production costs, logistics, resource availability and access to technology. Now, we discuss each of these aspects. Production Costs: Companies invest in foreign countries in order to avail the benefits of lower production costs like low labour costs, land prices, commercial real estate rents, tax rates etc. Gum Sung plastics- a South Korean firm- established its manufacturing facilities in Mericali, Mexico and saved two thirds of the labour cost. Logistics: If the costs of transportation from the domestic country to a foreign market is high and or the time of transportation of the products to a foreign market is long then the firms undertake FDI. Coca-Cola selected the FDI strategy as the cost of transportation by heavy because most part of its 35

8 product by water. Heineken also selected the strategy of FDI as it finds it cheaper to brew its beverages in foreign locations where customers reside. Availability of Natural Resources: Companies locate their production facilities close to the source of critical inputs. The US based oil refining companies established their oil refining facilities in Saudi Arabia and other Gulf countries. However, some firms recently prefer FDI to develop technology jointly with foreign firms. Availability of Quality Human Resource at Low Cost: High quality human resource contributes to high value addition to the product/service. Further, if such human resource is available at low cost, the level of productivity in monetary terms is higher and the cost of value addition is still lower. As such high quality human resources at low cost attract FDI. India, South Korea, Malaysia, China and Thailand attract FDI, as the cost of operation of business in these countries is relatively less. Access to Key Technology: Firms go with FDI in order to have access to existing key technology rather than developing new technologies Demand Factors Companies also select the FSI strategy in order to increase the total demand and their products. These factors include: Customer access, marketing advantages, exploitation of competitive advantages and customer mobility. Customer Access: Certain business firms particularly fast food, service oriented and retail outlets should locate their operations close to customers. KFC, Toys R us, Aetna locate their operations close to customers in order to increase the demand and their products or services. Marketing Advantages: Companies can enjoy a number of marketing advantages by locating their operations in a host country. These advantages include lower marketing costs, accessibility to hands on experience regarding customer and market handling, improving customer service etc. Delta products of Taiwan-produces battery packs and laptop computers shifted its operation to US-Mexican border in order to meet the US customer needs quickly and flexibly. Exploitation of Competitive Advantages: Companies which enjoy competitive advantages through trade mark, brand name, technology etc., go 36

9 with FDI in order to exploit its competitive advantages in various foreign markets. As explained earlier, the decision is based on the cost of contract negotiation, implementation and control. Customer Mobility: The companies which have one or a few customers select the FDI strategy along with their customers. In other words, the ancillary industrial units locate their production facilities in those foreign countries where their parent companies locate their production facilities. The business firms supplying parts to Japanese automobile companies located their production facilities in the USA along with the Japanese automobile companies. Six Korean parts suppliers to Samsung located their operations in England when Samsung constructed its electronics factory in northeast England Political Factors Companies enter foreign markets through FDI in order to overcome the trade barriers imposed by the host country and/or to avail the incentives offered by the host Governments. Avoidance of Trade Barriers: Companies establish production facilities in foreign markets in order to avoid trade barriers like high export tariffs, quotas etc. Japanese automobile companies established factories in the USA when the US Government increased import tariff rates in order to protect domestic automobile companies. Economic Development Incentives: Governments at different levels i.e., local, State and National levels offer incentives to attract domestic as well as foreign investment. Indian Government as well as Government of Andhra Pradesh offered a number of incentives to FDI. These incentives include low tax rate, development of infrastructural facilities, employee training programmes etc. 2.3 Reasons for FDI As explained earlier, FDI is the ownership and control over assets held in foreign countries. There are a number of reasons for FDI. These reasons include: increase in 37

10 sales and profits, enter rapidly growing markets, reduce costs, consolidate trade blocs, protect domestic markets, protect foreign markets, and acquire technological and managerial know-how. Now, we shall discuss these reasons. To Increase Sales and Profits: Companies invest capital directly in various foreign countries in order to increase sales and profits. This is because foreign markets offer more attractive opportunities for business than domestic markets. For example, Mitsubishi, Toyota and Mercedes increased their sales in the USA, whereas General Motors, Ford and Chrysler increased their sales in Europe. Coca-Cola has been earning more profits in foreign countries than in the USA. To Enter Fast Growing Markets: Some international markets grow at a fast rate than other markets. The fast growing markets provide better opportunity to MNC for their business growth. IBM entered Japan laptop market through FDI during the earlier 1990s as the Japanese laptop market had grown by 40 per cent during that period. To Reduce Costs: MNCs invest in foreign countries with view to reduce cost of production and various other operations. This is due to the availability of various inputs like raw material, human resources etc., at lower price in foreign countries. Some of the software companies invested in India due to lower human resource costs in India. Similarly, domestic companies invest in foreign markets due to lower transportation costs and energy costs, Japanese steel firms moved to the USA due to lower transportation. The US firms moved to Mexico, South Korea, Taiwan, Hong Kong, India, China etc., in order to utilize te opportunity of lower costs. To Consolidate Trade Blocs: MNCs prefer to do business with other member countries of the trade bloc. This is because the MNCs get preferential treatment in doing business. To Protect Domestic Markets: Some MNCs invest and operate in foreign markets with a view to avoid the competition wit the weak domestic firms. In other words, they leave the domestic market to the less competitive domestic firms. To Protect Foreign Markets: Some MCs invest in foreign countries in order to protect foreign markets. British Petroleum invested in the USA and protected the declining service stations. 38

11 To Acquire Technological and Managerial Know-How: Sometimes the technological and managerial know how in various foreign countries might be superior to those of domestic country. In such cases MNCs invest in foreign countries in order to acquire the superior foreign technological and managerial know-how. For example, the US companies acquired the technological as well as managerial know how from Japan by investing in Japan. Kodak established the world class research facilities in Japan. 2.4 Costs and Benefits of FDI FDI has its costs and benefits to the home country as well as host country. Now, we shall discuss the costs and benefits of FDI to home country Benefits to Home Country Inflow of foreign currencies in the form of dividend, interests etc. Nissan s profits repatriated to Japan are from its FDI in the UK. They helped Japan for positive balance of payments. FDI increases export of machinery, equipment, technology etc. from the home country to the host country. This in turn enhances the industrial activity of the home country. The increased industrial activity in the home country enhances employment opportunities. The firm and other home country firms can learn skills from its exposure to the host country and transfer those skills to the industry in the home country Costs to Home Country There are costs to the home country, in addition to benefits form the FDI. They include: Home country s industry and employment position are at stake when the firms enter foreign markets due to low cost labour. The US textiles moved to Central America. This resulted in retrenchment in USA. Current account position of the home country suffers as FDI is a substitute for direct exports. 39

12 2.4.3 Benefits to Host Country Resource-Transfer Effects: The resources which are scarce in host country are transferred from the foreign country. These resources include foreign capital, technology, machinery and equipment, management and organization. Transfers of these resources develop the host country economically and socially. Indian government has been encouraging the FDI after 1991 to develop the Indian industry, infrastructure and service sectors. Employment Effects: The FDI contributes for the establishment of new industries and business directly and for the employment of existing economic activity. Further, FDI helps for the developing of ancillary industries. These developments invariably increase the employment opportunities for the people of the host country. Balance of Payments Effects: Balance of payments position and foreign exchange resources are very crucial from the view point of external situation of country. India faced severe foreign exchange resource crunch and thereby unfavourable balance of payments position before July In fact this adverse position forced the Indian government to announce economic liberalization in July FDI provides capital for the production of a number of goods and services domestically. This in turn reduces the imports and thereby improves the current account position of the host country s balance of payment. Further, the foreign companies export the goods, produced in the host country to a number of other countries. This activity helps the host country to have foreign exchange earnings. For example, Nissan established its plants in the UK and exports 80% of its automobiles to other countries and improved Britain s balance of payments Costs to Host Country Though the FDI benefits the host country and also cost the host country. Its cost are in the form of intensifying competition, negative effects on balance of payments and impact on national sovereignty and autonomy. 40

13 Intensifying Competition: Foreign MNCs have more competitive abilities in view of their large size, resource base and widespread operations than thoseof the domestic companies. Hence, they pose severe competition and threat to the domestics. Negative Effects on the Balance of Payments: The foreign companies affect the balance of the host country in three ways: i. Foreign companies repatriate the dividends to their home countries that affect the current account. Coca-Cola initially invested US $18 million in India and it transferred US $54 million to the USA in the form of dividends. The foreign firms may purchase and sell the machinery and equipment that affect the capital account transactions. ii. The MNC in the host country imports the goods from its subsidiaries from other countries. These imports result in a debit on the current account of the balance of payments of the host country. Japanese automobiles operating in the USA, extensively import components parts from Japan. These imports substantially resulted in adverse balance of payments position of the USA. iii. National Sovereignty and Autonomy: Some of the host governments fear FDI as it affects the sovereignty and autonomy of the country. In fact, some of the MNCs destabilize the governments in African countries. But the economists of the advanced countries dismiss these criticisms as groundless, irrational and silly Implications of FDI for Business The following implications of FDI for business: Location-specific advantages argument indicates the flow of FDI in order to take the advantage of mineral and other resources in foreign countries. If the costs of transportation are minimum, it would be preferable for the companies to export. The firm can go for licensing if the know how is not valuable. If the company s skills and capabilities are not available for licensing, better the company go for FDI. 41

14 2.5 Foreign Direct Investment Policy of India As part of the economic reforms programme, policy and procedures governing foreign investment and technology transfer have been significantly simplified and streamlined Automatic Route Today, foreign investment is freely allowed in all sectors including the services, sector except in cases where there are sectoral ceilings. All items/activities except the following are under the automatic route for foreign direct investment (FDI): i. All proposals that require an industrial Licence. An industrial Licence is mandatory if: a. the item involved requires on industrial licence under the Industries (Development & Regulation) Act, 1951 or b. the foreign equity portion is more than 24% of the equity capital of units manufacturing items reserved for small scale industries; or c. the item concerned requires on industrial Licence in terms of the locational policy ii All proposals in which the foreign collaborator has a previous venture or tie-up in India. (Excluding IT Sector). iii All proposals relating to the acquisition of shares in an existing Indian company in favour of a foreign investor. a. iv. All proposals outside the notified sectoral policy/caps, or under sectors in which FDI is not permitted Investment in public sector units as also in Export Oriented Units (EOUs), and units in Export Processing Zones (EPZs), Special Economic Zones (SEZs), Software Technology Parks (STPs) and Electronics Hardware Technology Parks (EHTPs) also quality for the Automatic Route. FDI in the Sector up to 26%, is allowed under the automatic route subject to licence from the insurance regulatory & development Authority for undertaking insurance activities. In addition to Automatic Approval for new companies, such approval can also be granted for existing companies proposing to induct foreign 42

15 equity, for existing companies with an expansion programme, the additional requirements are that:- i. the increase in equity level must result from the expansion f the equity base of the existing company. ii. the money to be remitted should be in foreign currency, and iii. the proposed expansion programme should be predominantly in the sector(s) under automatic route. For existing companies without an expansion programme, the additional requirements for eligibility for automatic approval are : i. they should be engaged predominantly in industries under the automatic route. ii. the increase in equity level must be from expansion of the equity base, and iii. the foreign equity must come in foreign currency. Otherwise, the proposal would need Government approval through the Foreign Investment Promotion Board (FIPB). Investors coming through the Automatic Route are required to file relevant documents with the Reserve Bank of India within 30 days after the issue of shares to foreign investors. Proposals which do not fulfil the conditions for automatic approval will require the approval of the Government. The investors have to make an application to the Foreign Investment Promotion Board, Ministry of Commerce & Industry, Udyog Bhawan, New Delhi, for obtaining such approval Foreign Investment Policies-Procedures Foreign Direct Investment (FDI) inflows for the year Cumulative amount of Foreign Direct Investment (FDI) flows into India from April 2000 to March 2010 amounted to US$ billion. It covers the equity inflows, including data on re-invested earnings & other capital, available from April 2000 onwards. Cumulative amount of Foreign Direct Investment (FDI) equity inflows (from August 1991 to March 2010) stood at US$ billion. Foreign Direct Investment (FDI) equity inflows of US$ billion were received during the financial year (from April 2009 to March 2010) 43

16 covering the equity inflows, including (Provisional) data on re-invested earnings & Other capital compiled at the end of the financial year. Under the extant Foreign Direct Investment (FDI) policy, FDI upto 100 percent is allowed under the automatic route in most sectors/activities, except a few, where sectoral equity/entry route restrictions have been retained. FDI, under the automatic route, does not require any approval and only involves intimation to the Reserve Bank of India within 30 days of inward remittances and/or issue of shares to non-residents. Recent Policy Initiatives during Guidelines for calculation of total foreign investment i.e. direct and indirect foreign investment in Indian companies: Salient features All investment directly by a non-resident entity into the Indian company would be counted towards foreign investment. The foreign investment through the investing Indian company would not be considered for calculation of the indirect foreign investment in case of Indian companies which are 'owned and controlled' by resident Indian citizens and Indian Companies which are owned and controlled ultimately by resident Indian citizens. For cases where this condition is not satisfied or if the investing company is owned or controlled by 'non resident entities', the entire investment by the investing company into the subject Indian Company would be considered as indirect foreign investment. As an exception, the indirect foreign investment in only the 100 percent owned subsidiaries of operating cum-investing/ investing companies will be limited to the foreign investment in the operating-cum investing/ investing company. This exception has been made since the downstream investment of a 100 percent owned subsidiary of the holding company is akin to investment made by the holding company and the downstream investment should be a mirror image of the holding company. In the I & B (Information and Broad casting) and Defence sectors where the sectoral cap is less than 49 percent, the company would need to be 'owned and controlled' by resident Indian citizens and Indian companies, which are owned 44

17 and controlled by resident Indian citizens. For this purpose, the equity held by the largest Indian shareholder would have to be at least 51 percent of the total equity. Any foreign investment already made in accordance with the guidelines in existence prior to issue of this Press Note would not require any modification to conform to these guidelines. All other investments, past and future, would come under the ambit of these new guidelines Guidelines for transfer of ownership or control of Indian companies in sectors with caps resident Indian citizens to non-resident entities: Salient features Government/FIPB approval will be required in sectors with caps where: An Indian company is being established with foreign investment and is owned by a non-resident entity; or An Indian company is being established with foreign investment and is controlled by a non resident entity; or The control of an existing Indian company, currently owned or controlled by resident Indian citizens and Indian companies, which are owned or controlled by resident Indian citizens, will be/is being transferred/passed on to a nonresident entity, as a consequence of transfer of shares to non-resident entities through amalgamation, merger, acquisition etc; or The ownership of an existing Indian company, currently owned or controlled by resident Indian citizens and Indian companies, which are owned or controlled by resident Indian citizens, will be/is being transferred/passed on to a non-resident entity as a consequence of transfer of shares to non-resident entities through amalgamation, merger, acquisition etc Policy for downstream investment by Investing Indian Companies The guidelines clarify the need for obtaining government/fipb approval (or otherwise) for foreign investment into Indian companies, which can be either: Operating companies; or Investing companies; or Operating-cum-investing companies; or Neither of the above 45

18 It has been clarified that operating companies, as well as operating-cum-investing companies, need to comply with relevant sectoral conditions on entry route, conditionalities and sectoral caps. Investing companies, as well as companies which are neither investing nor operating companies, require prior Government/FIPB approval for infusion of foreign investment, regardless of the amount or extent of foreign investment. Downstream investments by investing companies, as well as operating-cum-investing companies, would need to comply with relevant sectoral conditions on entry route, conditionalities and sectoral caps Foreign Direct Investment (FDI) into a Small Scale Industrial Undertaking (SSI)/ Micro & Small Enterprises (MSE) and in Industrial Undertaking manufacturing items reserved for SSI/ MSE clarification It has been clarified that: The present policy on Foreign Direct Investment (FDI) in micro and small enterprises (MSE) permits FDI subject only to the sectoral equity caps, entry routes, and other relevant sectoral regulations. Any industrial undertaking, with or without Foreign Direct Investment (FDI) which is not a micro and small enterprises (MSE), manufacturing items reserved for manufacture in the MSE sector (presently 21 items) as per the Industrial Policy, would require an Industrial Licence under the Industries (Development & Regulation) Act 1951, for such manufacture. Such an industrial undertaking would also require prior approval of the Government (FIPB) where foreign investment is more than 24 percent in the equity capital. 2.6 Liberalization of Foreign Technology Agreement Policy The Government of India has reviewed the payment of royalties under Foreign Technology Collaboration, which provides for automatic approval for foreign technology transfers involving payment of lumpsum fee of US$ 2 million and payment of royalty of 5 percent on domestic sales and 8 percent on exports. Now, 46

19 Government of India has decided to permit payment for royalty, lumpsum fee for transfer of technology and payments for use of trademark/brand name on the automatic route i.e. without any approval of the Government of India. All such payments will be subject to Foreign Exchange Management (Current Account Transactions) Rules, 2000, as amended from time to time. 2.7 Review of cases under Government Route i.e. which require prior approval of the Government of India for making foreign investment Proposals for foreign investment under Government route i.e. requiring prior approval from the Government of India as laid down in the FDI policy from time to time, are considered by the Foreign Investment Promotion Board (FIPB) in Department of Economic Affairs (DEA), Ministry of Finance. The Government of India has reviewed the extant policy and it has been decided, that the following approval levels shall operate for proposals involving Foreign Direct Investment under the Government route i.e. requiring prior Government approval: (a) The Minister of Finance who is in-charge of Foreign Investment Promotion Board (FIPB) would consider the recommendations of FIPB on proposals with total foreign equity inflow of and below US$ million (Rs.1200 crore). (b) The recommendations of FIPB on proposals with total foreign equity inflow of more than US$ million (Rs crore) would be placed for consideration of Cabinet Committee on Economic Affairs (CCEA).The FIPB Secretariat in DEA will process the recommendations of FIPB to obtain the approval of Minister of Finance and CCEA. (c) The CCEA would also consider the proposals which may be referred to it by the FIPB/ the Minister of Finance (in-charge of FIPB). It has also been decided that companies may not require fresh prior approval of the Government i.e. minister in-charge of FIPB/CCEA for bringing in additional foreign investment into the same entity, in the following cases: (a) Cases of entities whose activities had earlier required prior approval of Foreign Investment Promotion Board (FIPB)/Cabinet Committee on Foreign Investment (CCFI)/Cabinet Committee on Economic Affairs (CCEA) and who had, accordingly, earlier obtained prior approval of FIPB/CCFI/CCEA for their initial foreign 47

20 investment but subsequently such activities/sectors have been placed under automatic route; (b) Cases of entities whose activities had sectoral caps earlier and who had, accordingly, earlier obtained prior approval of FIPB/CCFI/CCEA for their initial foreign investment but subsequently such caps were removed/increased and the activities placed under the automatic route; provided that such additional investment along with the initial/original investment does not exceed the sectoral caps; and (c) The cases of additional foreign investment into the same entity where prior approval of FIPB/CCFI/CCEA had been obtained earlier for the initial/original foreign investment due to requirements of Press Note 18/1998 or Press Note 1 of 2005 and prior approval of the Government under the FDI policy is not required for any other reason/purpose. 2.8 Investment Routes Entry Strategies for Foreign Investors A foreign company planning to set up business operations in India has the following options: As an Indian Company A foreign company can commence operations in India by incorporating a company under the Companies Act, 1956 through Joint Ventures; or Wholly Owned Subsidiaries Foreign equity in such Indian companies can be up to 100% depending on the requirements of the investor, subject to equity caps in respect of the area of activities under the Foreign Direct Investment (FDI) policy Joint Venture with an Indian Partner Foreign Companies can set up their operations in India by forging strategic alliances with Indian partners. Joint Venture may entail the following advantages for a foreign investor: Established distribution/ marketing set up of the Indian partner 48

21 Available financial resource of the Indian partners Established contacts of the Indian partners which help smoothen the process of setting up of operations Wholly Owned Subsidiary Company Foreign companies can also to set up wholly owned subsidiary in sectors where 100% foreign direct investment is permitted under the FDI policy Incorporation of Company For registration and incorporation, an application has to be filed with Registrar of Companies (ROC). Once a company has been duly registered and incorporated as an Indian company, it is subject to Indian laws and regulations as applicable to other domestic Indian companies As a Foreign Company Foreign Companies can set up their operations in India through Liaison Office/Representative Office Project Office Branch Office Such offices can undertake any permitted activities. Companies have to register themselves with Registrar of Companies (ROC) within 30 days of setting up a place of business in India Liaison office/ Representative office Liaison office acts as a channel of communication between the principal place of business or head office and entities in India. Liaison office cannot undertake any commercial activity directly or indirectly and cannot, therefore, earn any income in India. Its role is limited to collecting information about possible market opportunities and providing information about the company and its products to prospective Indian customers. It can promote export/import from/to India and also facilitate technical/financial collaboration between parent company and companies in India. The approval for establishing a liaison office in India is granted by the Reserve Bank of India (RBI). 49

22 Project Office Foreign Companies planning to execute specific projects in India can set up temporary project/site offices in India. RBI has now granted general permission to foreign entities to establish Project Offices subject to specified conditions. Such offices cannot undertake or carry on any activity other than the activity relating and incidental to execution of the project Branch Office Foreign companies engaged in manufacturing and trading activities abroad are allowed to set up Branch Offices in India for the following purposes: Export/Import of goods Rendering professional or consultancy services Carrying out research work, in which the parent company is engaged. Promoting technical or financial collaborations between Indian companies and parent or overseas group company. Representing the parent company in India and acting as buying/selling agents in India. Rendering services in Information Technology and development of software in India. Rendering technical support to the products supplied by the parent/ group companies. And Foreign Airline/shipping Company. A branch office is not allowed to carry out manufacturing activities on its own but is permitted to subcontract these to an Indian manufacturer. Branch Offices established with the approval of RBI, may remit outside India profit of the branch, net of applicable Indian taxes and subject to RBI guidelines Permission for setting up branch offices is granted by the Reserve Bank of India (RBI) Branch Office on "Stand Alone Basis" Such Branch Offices would be isolated and restricted to the Special Economic zone (SEZ) alone and no business activity/transaction will be allowed outside the SEZs in India, which include branches/subsidiaries of its parent office in India. No approval shall be necessary from RBI for a company to establish a branch/unit in SEZs to undertake manufacturing and service activities subject to specified conditions. 50

23 2.9 Sector wise Regulation in Foreign Investment Automatic route for specified activities subject to Sectoral Cap and conditions Table 2.1 Automatic route for specified activities with sectoral cap Sectors Airports Existing Greenfield Air Transport Services Non Resident Indians Other Cap 74% 100% 100% 49% Alcohol distillation and brewing 100% Banking (Private Sector) 74% Coal and Lignite mining (specified) 100% Coffee, Rubber processing and warehousing 100% Construction and Development (Specified projects) 100% Floriculture, Horticulture and Animal Husbandry 100% Specified Hazardous chemicals 100% Industrial Explosives Manufacturing 100% Insurance 26% Mining (Precious metals, Diamonds and stones) 100% Non banking finance companies ( conditional) 100% Petroleum and Natural gas Refining (private companies) 100% Other areas 100% Power generation, transmission, distribution 100% Trading Wholesale cash and carry 100% Trading of Exports 100% SEZ s and Free Trade Warehousing Zones 100% Telecommunication Basic and cellular services 49% ISP with gateways, radio paging, end-end bandwidth 49% ISP without gateway (specified) 49% Manufacture of telecom equipment 100% 51

24 2.9.2 Prior Approval from FIPB where investment is above Sectoral caps for activities listed in table 2.2: Table 2.2 Activities needed Prior Approval from FIPB where investment is above Sectoral caps Sectors New Investment by a foreign investor in a field in which the investor already has an existing joint venture or collaboration with another Indian partner New investment sought to be made in manufacture of items reserved for Small Scale Industries Broadcasting Cap 74% to 100% 49% 74% o FM Radio 20% o Cable network 49% o Direct-To-Home (DTH) 49% o Setting up hardware facilities 49% o Uplinking news and current affairs 26% o Uplinking non-news, current affairs TV channel 100% Cigarette manufacturing 100 % Courier services other than those under the ambit of Indian Post Office Act, % Defence production 26 % Investment companies in infrastructure / service sector (except telecom) 49 % Petroleum and natural gas refining (PSU) 26 % Tea Sector including Tea plantation 100 % Trading items sourced from Small scale sector 100 % Test marketing for equipment for which company has approval for manufacture 100 % Single brand retailing 51 % Satellite establishment and operations 74 % Print Media o o Newspapers and periodicals dealing with news and current affairs Publishing of scientific magazines / specialty journals periodicals Telecommunication o o o Basic and unified access services ISP with gateways, radio paging, end to end bandwidth ISP with gateway (specified) 26 % 100 % 49 % to 74 % 49 % to 74 % 49 % to 100 % 52

25 2.9.3 The activities attract equity cap for FDI (refer table 2.3) Table 2.3 Activities attract equity cap for FDI S. No. Sector FDI cap (in %) Activities 1. Telecom basic, cellular, value-added services, global mobile personal communications by satellite internet service providers with gateways, radio paging and end-to-end bandwidth 2. Coal & Lignite public sector undertakings other than public sector undertakings for exploration & mining of coal or lignite for captive consumption 3. Mining 74 exploration and mining of diamonds and precious stones 4. Private Sector Banking 49 private banking sector 5. Insurance 26 insurance sector (subject to obtaining license from IRDA) 6. Domestic Airlines 40 no direct or indirect equity participation by foreign airlines 7. Petroleum (Other than refining) Refining in unincorporated joint venture in incorporated joint venture petroleum products and pipelines sector in infrastructure related marketing and marketing of petroleum products for public sector undertakings 8. Investing companies in Infrastructure /Service sectors 49 investment through such vehicle is treated as resident equity 53

26 9. Atomic minerals 74 a. mining and mineral separation; b. value addition; c. integrated activities. 10. Defence industry sector 26 for arms and ammunition and allied items of defence equipment, defence aircraft and warships 11. Broadcasting Setting up hardware facilities, such as uplinking, HUB, etc. Cable network Direct-to- Home Terrestrial Broadcasting FM (portfolio investmen t) Private companies incorporated in India with permissible FII/NRI/OCB/PIO equity within the limits (as in the case of telecom sector FDI limit up to 49% inclusive of both FDI and portfolio investment) to set up up linking hub (teleports) for leasing or hiring out their facilities to broadcasters Foreign investment allowed up to 49% (inclusive of both FDI and portfolio investment) of paid up share capital. Companies with minimum 51% of paid up share capital held by Indian citizens are eligible under the Cable Television Network Rules (1994) to provide cable TV services. Companies with a maximum of foreign equity including FDI/NRI/OCB/FII of 49% would be eligible to obtain DTH License. Within the foreign equity, the FDI component not to exceed 20%. The licensee shall be a company registered in India under the Companies Act. All share holding should be held by Indians except for the limited portfolio investment by FII/NRI/PIO/OCB subject to such ceiling as may be decided from time to time. Company shall have no direct investment by foreign entities, NRIs and OCBs. As of now, the foreign investment is permissible to the extent of 20% portfolio investment. No private operator is allowed in terrestrial TV transmission 12 Small Scale Industries (SSI) sector 24 FDI in an SSI unit exceeds 24% of the paid up capital then the company loses its SSI status. Further, if the item/s of manufacture is/are reserved for SSI sector, 54

27 the company has to obtain an industrial license and undertake a minimum export obligation of 50% of annual production on such products 13. Satellites 74% Establishment and operation of Satellites 14. Tea Sector 100%* FDI permitted in Tea sector, including tea plantations requiring prior Government approval * subject to compulsory divestment of 26% equity of the company in favour of an Indian partner/indian public within a period of five years. 15. Print Media 74%** 26%** In Indian entities publishing scientific/technical and speciality magazines/periodical/journals In Indian entities publishing newspapers and periodicals ** subject to guidelines notified by Ministry of Information & Broadcasting from time to time India Opens up Key Sectors for Foreign Investment further India has liberalized foreign investment regulations in key sectors, opening up commodity exchanges, credit information services and aircraft maintenance operations. The foreign investment limit in Public Sector Units (PSU) refineries has been raised from 26% to 49%. An additional sweetener is that the mandatory disinvestment clause within five years has been done away with. FDI in Civil aviation up to 74% will now be allowed through the automatic route for non-scheduled and cargo airlines, as also for ground handling activities. 100% FDI in aircraft maintenance and repair operations has also been allowed. But the big one, allowing foreign airlines to pick up a stake in domestic carriers has been given a miss again. India has decided to allow 26% FDI and 23% FII investments in commodity 55