Themes > Features

27.06.2000

FDI and the Balance of Payments during the 1990s

A major component of the economic reform initiated in the 1990s was, and remains, the liberalisation of regulations relating to the inflow and terms of operation of foreign direct investment. Successive governments, inspired by the Chinese experience, have set themselves the target of taking the annual inflow of such investment to $10 billion. To this end, ceilings on foreign shareholding have been liberalised and raised to as much as 100 per cent in many industries, approval has been rendered automatic across a wide range of industries as a precursor to the proposed abolition of the suitably renamed Foreign Investment Promotion Board (FIPB), regulations with regard to dividend repatriation and payments in the form of royalties and technical fees have been eased, and the government, especially the one in power currently, has stretched itself in all manner of ways to prove that that it is foreign-investor friendly.
 
These efforts notwithstanding, the record with respect to foreign investment, is indeed disappointing relative to expectations. The inflow of foreign direct investment in 1999-2000 amounted to $2.2 billion (Chart 1), which is not merely way below the $10 billion target, but in fact lower than the peak of $3.6 billion it touched in 1997-98. The decline in FDI inflows in recent years has meant that the ratio of foreign direct to foreign portfolio investment, which rose from 16 per cent in 1993-94 to 195 per cent in 1997-98, has since fallen to 71 per cent in 1999-2000. (Recently, however, the government has chosen to treat inflows resulting from the sale of ADRs and GDRs by Indian companies in international markets as direct as opposed to portfolio investment. This would, for purely definitional reasons, improve the direct to portfolio ratio in the current financial year.)

Despite the indifferent level of FDI inflow relative to target, an inter-temporal comparison improves the picture substantially. FDI inflows, which stood below $100 million in 1990-91, rose to cross the $1 billion mark by 1994-95 and increased almost three-fold in the subsequent three years. And though there are signs of a tapering off of such inflows over the last two financial years, the government's 'big-ticket' privatisation drive may in fact take the figure to levels above the 1997-98 peak. A degree of success in enhancing the quantum of FDI inflow cannot be denied.
 
An examination of the 'sources' of such inflow is of some interest (Chart 1a). To start with, non-resident investors, who were major direct contributors to the inflow of foreign investment during the first half of the 1990s, have been less conspicuous subsequently, pointing to a decline in NRI interest or to the fact that NRI funds are increasingly being routed through corporate bodies, which do not exploit concessions offered via the NRI window. However, the fact that inflows have slowed in the wake of the loss of 'direct; NRI interest is a factor to be noted.

Secondly, as is to be expected, the decline in flows through the NRI channel have substantially increased the share of investment routed through registration with the Secretariat of Industrial Approval (SIA), the FIPB and the RBI. Not all of this, it must be noted, is investment in greenfield projects. In the wake of liberalisation of ceilings on foreign shareholding, from the 40 per cent level required for national treatment under FERA, a number of companies already in operation in the country raised the foreign stake in their paid up capital through issue of new shares to the foreign investor. Many of those issues have occurred at prices way below the prevailing market values of the shares concerned, implying that the foreign stake has increased substantially based on a relatively small inflow of foreign capital. Unfortunately, the quantum of inflow under these heads is not separately available.
 
Further, there have been a large number of cases of foreign firms acquiring wholly India ones, epitomised by the purchase of soft-drinks giant Parle Exports by Coca Cola. Data relating to inflows on account of acquisition of shares of Indian companies by non-residents under section 29 of FERA is available from January 1996. As Chart 1 shows, the share of FDI inflows on this account has been substantial in recent years, accounting for 23 per cent of the total in 1999-2000.
 
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.
 
The available evidence suggests that this is precisely what is occurring in India. The Reserve Bank of India has periodically been publishing figures on the finances of Foreign Direct Investment Companies (FDICs), or companies in which a single non-resident investor has 10 per cent or more shares, for different sets of years in the 1990s. These firms are those, with the requisite foreign equity holding, included in the RBI's studies of the finances of a larger sample of public and private limited companies. It must be mentioned that neither do these data sets amount to a comprehensive census of FDICs nor are they a consistent sample in the sense that the firms covered remain the same in all years. However, as Chart 2 shows, these firms, numbering between 241 and 321 in individual years between 1990-91 and 1996-97, are predominantly modern firms operating in the Engineering and Chemicals sectors. Their performance can therefore be treated as being broadly representative of firms with a significant foreign interest operating in the country.

As Chart 3 shows, seen in terms of annual rates of growth of sales and fixed assets these firms registered substantial expansion starting 1993-94 when liberalisation really took off, and even though there were signs of a slow down in sales growth by 1996-97 (the last years for which figures are available), fixed asset expansion continued. On the other hand, the two variables that registered a deceleration in growth in the later reform years where export revenues and foreign exchange earnings, which were the indicators which the reform were expected to stimulate.

The deceleration in export earnings was, as expected in the argument delineated earlier, accompanied by a sharp increase in the import intensity of production by the FDICs (Chart 4). While the ratio of exports to sales stagnated in the 9 to 10 per cent range through the 1990s, the ratio of imports to sales rose in all years excepting for the year of stabilisation-induced import contraction, 1991-92. The import to sales ratio more than doubled between 1990-91 and 1996-97, rising from 7.8 per cent in 1990-91 to 8.5 per cent during 1992-94, 10.6 per cent in 1994-95, 12.8 per cent in 1995-96 and 16.3 per cent in 1996-97.

If we look at the overall foreign exchange expenditure by these firms we find that while non-import expenditures on royalties, dividends and the like did increase as well, the dominant increase was on account of imports (Chart 5). While imports rose 3.6 times from Rs.1916 crore in 19993-94 to Rs. 6979 crore in 1996-97, foreign exchange expenditure under heads other than exports rose from Rs. 356 crore to Rs. 1116 crore during the same period. Clearly the immediate impact of reform was to encourage foreign firms to offer 'newer', import-intensive products to exploit the pent-up demand we spoke of earlier. This is corroborated by the fact that the share of imported raw materials, components and spares in the total expenditure on such items by these firms, which fell from 18 to around 15 per cent in the wake of import contraction in 1991-92, subsequently rose to touch close to 21 per cent in 1996-97 (Chart 6).

Non-import expenditures too rose sharply, even though the smaller share of such expenditures in the total limited their impact on foreign exchange outflows. Thus, between 1990-91 and 1996-97, payments on account of dividends rose 2.6 times, those on account of royalties 6.4 times, and on account of professional and consultation fees by a multiple of 23.1 (Chart 7). While indicators such as the latter two may be taken as indicators of modernisation, the fact remains that they contributed little to actual export competitiveness.

The net impact of these developments on foreign exchange flows associated with the working of these enterprises is discernible from Chart 8. Net foreign exchange flows, which amounted to an inflow of Rs. 142 crore in 1990-91 and Rs. 529 crore in 1993-94, turned into an outflow of Rs. 186 crore in 1993-94. That outflow had risen to Rs. 340 crore by 1996-97. What is more, even in 1990-91, firms in sectors like Engineering and Chemicals, which were the ones receiving further investments in the subsequent years of liberalisation of FDI regulations, were already registering large outflows. It was only because of the inflows into firms in traditional sectors like Tea, Textiles and Leather, that the aggregate figure turned out to be positive. The evidence is clear that FDI of the kind that India has been receiving in the wake of liberalisation is a factor contributing to a foreign exchange drain rather to an enhancement of India's foreign exchange earning capacity.

It would, of course, be argued by the advocates of reform that the drain of foreign exchange on account of the operations of these firms is more than matched by the additional inflow in the form of equity capital. This argument, however, confuses the immediate inflow on account of foreign investment and the long term sustainability of inflows of the kind discussed. It is well known that foreign capital inflows into joint ventures in developing countries are in the nature of large one time flows for establishing or substantially expanding an enterprise accompanied by smaller 'in effect' inflows on account of retention of part of the profits due to the foreign partner, which are not paid out as dividends.
 
Once established much of the expansion of the firm occurs on the basis of borrowing from the domestic market, or issues of additional shares at a premium. Such issues are resorted to in the wake of the capitalisation of reserves through the issue of bonus shares to existing shareholders so that their stake in the company is not substantially diluted. In the case of the FDICs in the RBI sample for example, the share of funds used that were diverted to gross fixed assets formation rose from 33.9 per cent in 1991-92 to 42.2 per cent in 1993-94 and 73.5 per cent in 1996-97. During these years, the share of external sources of funds, consisting dominantly of borrowing from the domestic market, accounted for between 60 and 70 per cent of the total throughout the period (Chart 9). Expansion results in an increase in the fixed assets, sales and profits of the company concerned, which in turn increases outflows on account of imports and non-import foreign exchange expenditures like royalties that are tied to sales volumes.

Thus, unless exports increase significantly and bring in additional foreign exchange revenues, net inflows that are positive at the time when equity is flowing in soon turn negative, and within a short period cumulative inflows are negative. It is for this reason that the cumulative foreign exchange impact of foreign investments targeted at domestic markets inevitably tends to be negative. There is no reason to believe that given the nature of FDI flows into India during liberalisation the story would be any different.
 
This conclusion has a larger implication. The theology of liberalisation is based on the presumption that one of the features of globalisation is the emergence of large volumes of footloose capital in search of appropriate locations for world market production. Since every developing country would have some comparative advantage, it is argued, the liberalisation of trade and foreign investment rules would attract some of this capital, which would relocate the relevant capacities to the developing country concerned, to use it as a source for production for the world market. Investment flows would be accompanied by trade flows, including exports, making FDI either benign or virtuous from a balance of payments point of view. This argument regarding capital mobility is not theoretically obvious, since a range of factors can distort this picture of freely flowing capital that redresses production inequalities across the world. If it is to be valid, it must be empirically shown to be true. The available evidence relating to FDI during the liberalisation years suggests that it is not.