A recent press release issued by the Indian Government proposes to usher in 'radical' FDI-related reforms touching 15 major sectors of the economy.
By Bhargavi Zaveri and Radhika Pandey
A recent press release issued by the Indian Government proposes to usher in 'radical' FDI-related reforms touching 15 major sectors of the economy. Key changes to the FDI framework include raising the limit for FDI approvals from the Foreign Investment Promotion Board (FIPB) to Rs 5,000 crore from Rs 3,000 crore, increasing foreign-investor limits in several sectors including private banks, defence and non-news entertainment media as well as allowing foreign investors to exit from construction development projects before completion.
Image Attributed: Bombay Stock Exchange, Mumbai, INDIA / Source: Wikimedia Commons
The stated objective of these reforms is to "ease, rationalise and
simplify the process of foreign investment" in the country. The reforms
comprise of easing sectoral caps in some sectors, moving some sectors from the
approval route to the automatic route and granting special dispensations to
entities owned and controlled by NRIs. These measures could benefit certain
sectors and augment FDI flows. Going forward, these measures may also propel
our investment rankings. However, like most reforms to the capital controls
framework of the post-1999 period, this purported reform also ignores the
substantive issues of ad-hocism, executive
discretion and the absence
of rule of law that pervade the administration of capital controls. Unless
we address these fundamental issues, incremental reforms of this nature will be
of little help.
This article focuses on four such mistakes that the recent press release continues
to make.
Distinguishing
between investment vehicles
Principle: The capital controls framework should be agnostic to the
channel through with foreign money is being routed. The relation between
ownership and management which is the basis for distinction between a company
and a Limited Liability Partnership should not be a concern for the capital
controls framework.
Today, FEMA has different rules for treating foreign investment made in an
Indian company, an Indian partnership firm, an Indian trust and an Indian LLP.
For example, while non-residents are allowed to invest in an Indian company,
only NRIs are allowed to invest in an Indian partnership firm on a
non-repatriation basis. Foreign investment in a LLP is allowed only under the
Government route. Moreover, to be eligible to accept FDI, the LLP must be
operating in a sector where 100% FDI is allowed under the automatic route and
where there are no FDI-linked performance conditions. Further, a LLP having
foreign investment is not allowed to make downstream investment in India.
The press release proposes to allow FDI in a LLP under the automatic route. It
also proposes to allow a LLP with FDI to make downstream investment in a sector
in which 100% FDI is allowed under the automatic route and there are no
FDI-linked performance conditions.
A liberalisation policy must be indifferent to the vehicle through which FDI
comes into India. Whether FDI comes in through a company or a LLP, the same
rules must apply. The reporting requirements may differ depending on the
investee entity. So, for instance, for LLPs or trusts with FDI, the regulatory
framework may prescribe more detailed reporting requirements, as compared to a
company with FDI. Restrictions on capital flows must not driven by the nature
of the investee entity.
By creating artificial restrictions which are driven by the nature of the
investing entity, the FDI policy only adds to the complexity of investing in
India. For example, take a situation where a foreigner is interested in
investing in an advertising agency, a sector where 100% FDI is allowed under
the automatic route. She makes the investment in a LLP engaged in advertising.
Now, the advertising agency proposes to expand into another activity, say,
print media which is under the Government route. Under the current policy, the
LLP will not be able to expand its operations as print media is under the
government route nor will it be able to incorporate another company, as under
the proposed policy, downstream investment by a LLP with FDI is permitted only
in sectors in which 100% FDI is allowed under the automatic route. However,
this problem would not crop up if she invests in an Indian company engaged in
advertising.
The press release allowing FDI in a LLP under the automatic route is, thus, a
mere addition to the error of mandating different rules for FDI in different
kinds of entities.
Special
dispensations to NRIs
Principle: For the purpose of administering capital controls, the rules
for foreign money should be similar whether it comes through an NRI owned and
controlled company or through other overseas investor.
Currently, NRIs have certain benefits as compared to other non-residents when
investing in India. The press release proposes to extend these benefits to
entities owned and controlled by NRIs. There are two issues involved here.
First, to address the concerns of money laundering and terrorist financing, the
entities owned and controlled by NRIs should only be allowed through the FATF
compliant jusridictions.
Second, this proposal tantamounts to revival of the concessions which were
granted to Overseas Corporate Bodies (OCBs) under FEMA, which were eventually
withdrawn in 2003. While the concerns relating to OCBs were largely related to
ownership of OCBs accessing the Indian securities markets under the Portfolio
route, OCBs were de-recognised as an investor class altogether. One of the
concerns regarding OCBs was the ownership of these OCBs, and whether they were
legit vehicles for investment by NRIs. Under the Consolidated FDI policy, a NRI
is allowed to invest in the capital of a partnership or proprietorship in India
on repatriation basis with the previous approval of RBI.
With the new framework in place, this benefit will be extended to entities
owned and controlled by NRIs. It is unclear how the framework will be
implemented to ensure that the shares of the foreign entities owned and
controlled by NRIs are not transferred to non-residents who are not NRIs. If
the NRIs want to sell their control, will the priveleges given to the companies
owned and controlled by NRIs have to be withdrawn? How will the Government know
if the company is still owned and controlled by NRIs. To avoid such
complexities a rational solution would be to move to harmonise the capital
controls framework for all kinds of non-resident investors--be it NRIs or
foreign investors.
There is no economic reason for treating a certain class of non-residents and
their investments differently from other non-residents. For example, this press
release proposes to exempt NRIs from the 3-year lock-in period imposed on
non-residents investing in the real estate sector. Presumably, the reason for
imposing a 3-year lock in period for foreign investors is to ensure that they
do not pre-maturely withdraw their capital from the project. There is no reason
for not applying this line of reasoning to investments made by NRIs in this
sector. Uniform treatment of all non-residents is more important to the ease of
doing business in India, than favouring NRI investments.
Sectoral
exemptions
Principle: Financial regulation including regulation of capital controls
should be motivated by market failure. The capital controls framework should
not be designed to protect Indian promoters. Contractual obligations between
the investor and investee should not be forcedthrough the capital
controls framework. The rules should provide a level playing field for all
investors.
A key highlight of the new FDI regime is that it allows foreign investors to
exit before the completion of the project in the construction sector. This is a
laudable step. At the same time, it imposes a lock-in period of three years
calculated with reference to each tranche of foreign
investment. This is undesirable. The terms and conditions on which a foreign
investor may exit an Indian real estate business, must be purely contractual
and based on commercial wisdom.
Further, certain sectors like Hotels and Tourist Resorts, Hospitals, Special
Economic Zones (SEZs), Educational Institutions, Old Age Homes and investment
by NRIs are proposed to be exempted from the condition of lock-in. It is difficult
to decipher the principles guiding the decision for exempting certain sectors
from the lock-in condition while imposing conditions on others. This creates
problems of political economy. Sectors which are not given the lock-in
exemption will be encouraged to lobby and persuade the authorities to add them
to the list of exempted sectors. This may result in undesirable consequences
including additional administrative workload without addressing any fundamental
market failure.
Booklet of
press releases and notifications relating to FDI
Principle: Capital controls must be administered through a legally
enforceable instrument. The complex of maze of regulatory instruments should be
replaced by one authoritarian position of law. The private sector then should
be free to make many ``user friendly documents".
Capital controls is governed by the Foreign Exchange Management Act, 1999
(FEMA). The RBI has the authority to frame regulations under the Act. Capital
controls is governed by foreign exchange management (FEM) regulations.
Amendments to these regulations must be tabled by the RBI (as notifications)
and approved by Parliament in order to be legally enforceable. The Department
of Industrial Policy and Promotion (DIPP), Ministry of Commerce and Industry, makes
policy pronouncements on FDI through Press Notes/Press Releases which are
notified by the Reserve Bank of India as amendments to the Foreign Exchange
Management (FEM) Regulations. The procedural instructions are issued by the
Reserve Bank of India through A.P. (DIR Series) Circulars. The RBI also issues
master circulars that act as a compendium of the notifications/circulars issued
in the previous year, without necessarily covering all the details. The DIPP
also issues a consolidated FDI policy that subsumes all Press Notes/Circulars
that were in force. The regulatory framework thus consists of Act, Regulations,
Circulars, Master Circulars, Press Notes, Press Releases and a Consolidated
Policy on FDI.
The press release proposes to add another instrument to this list. It instructs
the DIPP to consolidate all its instructions in a booklet so that investors do
not have to refer to several documents of different frames. The practice of
issuing binding instructions through `policy documents' is one of the most
fundamental errors of our capital controls framework. No amount of
consolidation or simplification can substitute this error.
Executive action which restricts the actions of private citizens must be taken
only through a legally enforceable instrument. This is because a legally
enforceable instrument has gone through the rigors of law making, will go
through some accountability mechanism (such as tabling before Parliament in
case of delegated legislation) and can be challenged in a court of law. `Policy
decisions' go through none of these checks and balances. There is also the
danger of easy reversal.
At present, the processes we follow for making the rules for entry and exit of
foreign investors in India are largely driven by `policy actions'. First, sectoral
caps, terms and conditions of foreign investment and its repatriation, are
virtually "regulated" through a policy document which neither goes
through the rigors of law making nor is subject to the accountability of
delegated legislation, such as tabling before Parliament. Second, even if the
policy is translated into a binding instrument (namely, regulations by RBI),
the process of translation suffers from time-lags and inconsistencies.
Conclusion
Improving the ease of doing business in India requires more than
sector-specific initiatives or making special dispensations. The problems run
deep. They are ultimately grounded in the Foreign Exchange Management Act,
1999, and the subordinate legislation and institutional machinery which
enforces it. Solving problems will require going to the root cause, as has been
recommended by numerous expert
committees.
About the Authors:
Bhargavi Zaveri (O-9136-2015), a public policy researcher associated with National Institute of Public Finance and Policy, New Delhi
Radhika Pandey (O-9133-2015), a researcher associated with National Institute of Public Finance and Policy, New Delhi
About the Authors:
Bhargavi Zaveri (O-9136-2015), a public policy researcher associated with National Institute of Public Finance and Policy, New Delhi
Radhika Pandey (O-9133-2015), a researcher associated with National Institute of Public Finance and Policy, New Delhi
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Publication Details:
This article was originally published at Dr Ajay Shah's Blog on November 12, 2015.
All rights reserved by the original publisher.
