Chief Economic Advisor Raghuram Rajan has revived interest in an issue that tends to be a favourite of the political class: the presumed superiority of Foreign Direct Investment (FDI) over Foreign Institutional Investment (FII).
The usual case that is made out is that FDI involves longer-term investment while FII funds can flow out overnight. But if we look at FDI and FII in terms of their macroeconomic effects, the choice is not so clear cut.
And a focus on this distinction may even distract us from the more fundamental constraints on the Indian economy’s ability to attract investment, both domestic and foreign.
The difference between individual investment decisions and their macroeconomic effects are probably best seen in the case of FDI. This investment can take the form of foreign companies investing in Indian ones to the point of buying them over.
The list of Indian companies that have been sold to foreign corporations includes such giants as Ranbaxy. In such cases, the macroeconomic impact depends on what the Indian seller does with the funds it receives.
It is quite possible that the Indian seller could reinvest the funds it receives in the Indian market. Parle used the funds from the sale of Thums Up and its sister brands to Coca Cola, to build Bisleri and the bottled water market in India.
But this need not be the pattern other sellers follow. It is quite possible, given the problems in investing in real-estate in India, that FDI in multi-brand retail would prefer to come in by buying majority shares in existing Indian retail chains. And since several of these Indian chains belong to business houses with significant investments abroad, the money earned from this sale could well be invested abroad. There need then be no net gain in investment in the Indian economy.
On the other side of the fence, it is quite possible for FII to have a longer-term impact. While individual investments from this source need not be long-term, a company that promises to keep growing will always find a substantial interest from stock markets.
The impact of this investment on the share price of that company would enable it to raise further funds, including through fresh issues of capital. FII interest as a whole in companies such as Infosys does have a longer-term impact on the ability of that company to raise capital.
The issue then is not so much what we do to attract FDI or FII, but what effect this investment has on the local economy. FDI that merely encourages Indian capital to move abroad can be as ineffectual as FII that does not lead to an increase in productive capacity. The challenge, then, is to attract longer-term investment in the Indian economy from both domestic and foreign capital.
It should not matter whether this investment goes directly into the creation of productive capacity or indirectly generates that capacity by raising a company’s share price and its ability to raise capital.
CAPITAL MARKET CHANGES
In this broader perspective, the problem is not with FII investment per se but with the links between this investment and productive capacity. In the effort to attract FII investment, conditions have been created that hurt this link. The link between stock markets and long-term investment was arguably the strongest in the 1980s. Reliance and several other companies used the stock market to raise the capital they needed for their investment in manufacturing.
An underestimated factor in this process was the role of local capital. Small companies that were known only locally could use the local stock market to raise capital. They could then grow enough to get on to the national and even international stage.
This link has been broken in the post-reforms era by the effective demise of regional stock exchanges. With this ladder being kicked away, there are fewer opportunities for small companies to take the Infosys or Reliance route to growth.
Without a strong link to productive capacity we cannot rule out the possibility of FII developing less desirable characteristics. It may even have become an effective replacement for the old hawala system of moving funds across national boundaries. Consider a case where those who are to receive funds in India first buy a large number of shares in a little known company. These transactions could be spread out over a long enough period of time not to have a speculative impact on the price of the share.
The foreign investor could then suddenly and very publicly invest a substantial amount in this company, thereby pushing up the price of this share. The original buyer could then sell their shares at the higher price. This would push down the price in the market and the FII would lose. But the funds would have been effectively transferred to India. A reverse of this process would take the funds abroad.
For FII to play a more productive role than being a de facto hawala system there is a need to create more opportunities for investment in small companies with growth prospects. This would, in turn, require a revival of the link between stock markets and local capital. The revival of regional stock exchanges may now be a more critical reform than opening up FDI in multi-brand retail.
(The author is Professor, School of Social Science, National Institute of Advanced Studies, Bangalore.)