A constant refrain in recent times is that India is losing out in the battle to attract foreign direct investment into the country. Even the Financial Times has more than once argued that India is experiencing a deceleration in FDI inflows as a result of a combination of factors varying from procedural bottlenecks in areas like mining, policy blockages or sheer fatigue with corruption (See issues dated June 1 and June 17 2011). To stall and reverse this decline, such observers argue, it is necessary to relax foreign investment policies further (as in multi-brand retail), raise ceiling on foreign participation, and be less stringent when it comes to implementing environmental and land acquisition norms. Some policy makers agree with them. India needs foreign funds to sustain high investment, but the flow of such funds is being constricted by stalled “reform” and arbitrary regulation, is the refrain.
The evidence to back this view is weak, to say the least. If we consider annual flows of foreign investment, what we find is that FDI flows registered a dramatic increase in 2007-08, from $23 billion to $35 billion, hovered around $38 billion during 2008-10 and then fell to a lower but still respectable $27 billion in 2010-11. The problem has not been the level of FDI flows but a degree of volatility. During these years, what are identified as portfolio flows have been even more volatile, fluctuating between a net inflow of $32 billion during the last two years (2009-11) and a negative $14 billion in the crisis year 2008-09.
Even if we examine quarterly figures, we find that FDI flows that rose from $6.9 billion in the second quarter of 2009 to a peak of $8.2 billion in the third quarter of that year, have since stayed in the 5-6 billion range for all but one quarter, namely January-March 2011. In fact, if we consider the 16 quarters ending Jan-March 2011, there have been only two in which FDI inflows stood at between $6-7 billion and four when it exceeded 7 billion. Thus, what the numbers point to is a degree of volatility around a $5-6 billion per quarter range, that cautions against reading too much into figures from any single quarter. In fact, no sooner had the Financial Times declared that foreign direct investment into India had “tumbled 32 per cent to just $3.4 billion” during January to March 2011 that it emerged that net FDI flows in the month of April alone amounted to $3.1 billion.
In sum, there is little evidence pointing to any major reversal in the trend of foreign direct investment flows into India in recent quarters or years. What is true is that while the combined figure for net foreign direct and portfolio investment flows into India has remained large through the recent period excepting for 2008-09, foreign direct investment has like portfolio investment begun to display a degree of volatility, even if not to the same degree. This leads to confusion since conventionally portfolio investment flows were seen as components of “hot money” flows that were volatile, whereas direct investment flows were seen as being more stable and less footloose.
There are two factors that could explain this tendency towards FDI volatility. The first is that the distinction between direct and portfolio investment may be blurring. This should not come as a surprise since though conceptually direct investment is treated as capital invested by entities with a more lasting, long-term interest in the host economy, the statistical (OECD) definition of a direct investment is any investment in equity by a single foreign shareholder that equals or exceed 10 per cent of the equity in a firm. Thus there could be a large number of investors with no lasting interest who get classified as direct investors because they buy into more than 10 per cent of equity, when they are essentially looking for returns in the short to medium term in the form of capital gains. With hedge funds and private equity firms looking to buy equity shares in the Indian financial space, the nature of the bets and the size of the investment would be substantially different. If for example, equity is being bought in a firm with the expectation that its value would appreciate since it is a likely target for a take over bid, the equity share held to attract bids from acquirers is bound to be higher. In India, the problem is compounded further because of the inclusion of foreign currency convertible preference shares and bonds in the definition of “equity”, even though there are or are more like debt instruments (Refer Smitha Francis, Economic and Political Weekly, may 29, 2010).
The other factor that could account for net FDI volatility is the recent tendency, encouraged by easy access to foreign exchange and relaxed rules regarding foreign investments outside India, for Indian firms to expand operations abroad through acquisition. The pace of foreign acquisition by Indian firms has increased considerably, with increases not just in the number but also the size of acquisitions. This would imply that a given gross inflow of foreign direct investment would amount to a significantly smaller net inflow of FDI. Since there are likely to be significant inter-temporal variations in the level of acquisitions, given the incipient nature of the tendency, this could aggravate the volatility of net FDI flows.
The implications are clear. We need to exercise caution in jumping to conclusions about changes in FDI flow trends based on short period data. We need to be even more careful when calling for changes in policy based on such short-term movements. Unless of course the evidence is merely a ruse to advance recommendations that would have been made anyway.