The fact that FDI inflows do not always reflect investments in greenfield projects is not without significance. Both foreign firms set up during the years when FERA limited foreign shareholding to 40 per cent and Indian companies established during the import substitution phase of Indian industrialisation were created with the domestic market as their primary targets. In the case of foreign firms, quantitative restrictions and high tariffs forced those that could earlier service the Indian market with exports from the parent or third-country subsidiaries to jump tariff barriers and set up capacity within the domestic tariff area in defence of existing markets. On the other hand, the large market 'opened up' to domestic entrepreneurs by protection, which was expanding as a result of state investment and expenditure, provided a major stimulus for the creation of new indigenous firms by Indian industrialists to cater to the local market. Such protection also ensured that profit margins on domestic sales exceeded that on exports, encouraging firms to focus on production for the home market. The government itself did little to counter this tendency generated in part by its own actions.
 
The inward-orientation of such firms was not merely because protection made the domestic market the target for these investors. Foreign firms which either invested in domestic capacity or licenced their technologies to domestic firms, were not keen on encouraging competition from capacity created in India in international markets being serviced by the parent firm or its third-country subsidiaries. Firms in India were virtually straitjacketed into servicing the large Indian market. The net result was that even when the world market for manufactures was expanding quite rapidly in the 1950s and 1960s, both foreign and domestic firms from India were conspicuous by their absence in international markets.
 
Given the evolution of these firms, it should be expected that any increase in the equity stake of the foreign investors in existing joint ventures or purchase of a share of equity by them in domestic firms does not automatically change the orientation of the firm. This implies that if FDI inflows in the wake of liberalisation are directed at enhancing foreign equity in 'rupee companies' registered in India but controlled by foreigners or into the acquisition of Indian companies occupying a prominent place in the Indian market, the aim of the investor is to benefit from the profits being earned by such firms in the Indian market. As a result, in such cases FDI inflows need not be accompanied by any substantial increase in exports, whether such investment leads to the modernisation of domestic capacity or not. This fact counters the presumption of many advocates of reform who argue that, in the context of globalisation, FDI flows reflect the need of large international firms to seek out the best locations for world market production, resulting in a virtuous nexus between foreign direct investment and exports.
 
This is not to say that there is no change in the nature and operations of foreign firms in a more liberalised context. Rather, since the relaxation of controls on FDI inflows under reform is accompanied by the liberalisation of the rules governing the operation of foreign firms and is accompanied by substantial trade liberalisation, we can expect two tendencies. First, there could be greater expenditure of foreign exchange by these firms on imported inputs. Second, there could be greater expenditure of foreign exchange because of the larger payments on account of royalties and technical fees and larger repatriation of profits as dividends encouraged by the more liberalised environment.
 
The first of these is most likely. To start with, foreign firms would seek to use trade liberalisation and the liberalisation of regulations with regard to use of international brand names, to cash in on the pent up demand among the more well-to-do for a range of product innovations available in the international market place, access to which was restricted in the protectionist phase. Even if the market for this range of 'new' products is small, they can be 'manufactured' and sold in the domestic market with relatively small investments at the penultimate stages of production, based on imported intermediates and components.
 
Secondly, reduced restrictions on imports can encourage the practice of 'transfer pricing' or imports from the parent or a third country subsidiary located in a tax-haven at inflated prices, so that profits are 'transferred' to firms in low tax locations. This obviously implies that the foreign exchange cost of domestic production is inflated further.
 
Together with the tendency to extract larger payments in the form of more 'open' transfers such as royalties and technical fees, the operations of foreign firms can for these reasons result in a significant drain of foreign exchange. To the extent that these tendencies are associated with investments focused on exploiting the domestic market, where the market shares of domestic producers are either bought out or eroded by competition from internationally known brands, there would be little by way of enhanced foreign exchange earnings to neutralise their adverse balance of payments consequences. In the even, the net balance of payments impact of FDI inflows can be negative.