Addressing Indian FDI

Thursday 11th June 2009

Neil Hodge

The Indian government has opened the door to FDI in a move that could have huge ramifications for ambitious companies in the burgeoning economy.

Speculation had been mounting for years that a relaxation of investment rules may be forthcoming, with the first signs coming after the Ministry of Commerce issued revised guidance in February on what constitutes a foreign holding in an Indian company. Since then, the government has said that “guidelines are being further simplified and made homogeneous and consistent across various sectors” to “provide an impetus to foreign investment.”

There are three main reasons that have prompted the reverse to its earlier policies. One is genuinely to open up FDI, especially in areas such as retail and the media. Another is to enable companies that are strapped for cash in the current crisis to bring in equity from abroad, and the third is to help foreign companies that want to gain bigger FDI stakes than are currently allowed.

The announcement in February first came as a statement after a cabinet meeting. That was followed by a statement from Kamal Nath, the commerce and industry minister. Then came the government’s Press Notes 2, 3 and 4, that broadly allow an Indian majority-owned and controlled holding company, which is 49 percent foreign owned, to invest in a “downstream” subsidiary or associate company without the 49 percent counting against the new company’s FDI limit, which enables more investment to continue. Effectively, this means that the restriction on cascading investment has been removed and, as David Roberts, at law firm Olswang, says, “provided the relevant company is an Indian company then foreign direct investment restrictions could fall away.”

While this may look good sense to boost the country’s share of foreign cash, there is a widespread suspicion that foreign companies intend to use it as a loophole to exceed permissible holdings. This is a particularly contentious issue in India because different industry sectors have different caps on the level of FDI that can be invested. For example, telecoms and IT sectors, which have attracted the most foreign interest over the past decade, have caps on FDI to ensure that they remain Indian.

Furthermore, the multi-brand retail sector has until now prohibited any foreign investment. FDI rules have only allowed single-brand retailers, such as Germany’s Metro, to open stores, while multi-brand retailers, such as Tesco and Wal-Mart, have only been allowed to deliver supply chain and back-office services. But that might change. Now, under the new rules (though there is still some confusion) if a Western retailer formed a joint venture with an Indian firm, that company could potentially acquire an Indian-based store group and run all of its operations – including “front door” retail services, such as store operations. It could also lead to the acquired company being rebranded using the Western retailer’s branding.

Last year, Tesco signed an exclusive franchise agreement with Trent, Tata’s retail arm, to provide extensive retail and technical services to support the development of its hypermarket business, Star Bazaar. Since the rules change, it is understood that Tesco and other UK companies have been seeking clarification over the new guidance issued by the government so that they can start multi-brand retail operations. Kishore Biyani, of retail giant Pantaloon Retail, has said that “this opens the way for front-door entry of foreign direct investment in organised retail.”

Complications
Such fears could be exacerbated by another major change announced at the same time. The Indian government has also said that various forms of foreign investment are to be merged for assessment purposes. This means that funds from foreign financial institutions, foreign stock markets (in the form of depository receipts) and bonds, and non-resident Indians, are all counted together with foreign direct investment instead of being assessed separately under different headings. While that may look practical, lawyers believe that it will lead to countless complications, and therefore loopholes, as existing permissions and investments are re-scrambled.
However, industry sources remain sceptical that the Indian government is committed to liberalisation. It has been suggested that a simplification of FDI norms is largely aimed at rescuing some domestic companies that are facing a financial crunch. Sources said that an easing of the entry restrictions for foreign retailers would be political dynamite and deeply unpopular among local businesses.

The scheme has also run into problems with the country’s finance ministry and central bank. Barely two months after the government announced these changes, the Reserve Bank of India (RBI) and the Finance Ministry have sought a comprehensive review of the new guidelines on several contentious issues cutting across sectors that include banking, financial services, insurance, real estate, infrastructure and airlines. The ministry fears that new guidelines could open up the floodgates for foreign investment in several sensitive sectors including gambling and agricultural plantations. In an internal note on the recent changes in policy, the ministry has expressed fears that in “one sweep any sectoral gap of 49 percent and below has become meaningless”.

“Whether this stance has been approved as such or is it an unintended liberalisation is not clear,” the note stated. The ministry also wants a method to be built in where violation of sectoral caps can be detected through a standard filing system either with the RBI or any sector regulator.

“For downward investment, there is no filing at all done or mandated with the RBI and therefore no violation can be detected,” the note said. While the new norms have been specified and approved by the cabinet, these will find legal sanctity only after they are notified under the Foreign Exchange Management Act (FEMA).

“This will have implications not only on the business model of the banks but also for the investee companies,” it said. So far there are only two categories of banks – Indian banks and foreign banks. A new hybrid category would create difficulty in compliance with minimum capitalisation norms, says the RBI. Moreover, the insurance sector, where FDI is capped at 26 percent, needs more clarity and uniformity, it said. The RBI is also against inclusion of foreign currency convertible bonds (FCCBs) as foreign investment could lead to ambiguities because bonds are treated as borrowings until conversion into shares.

The finance ministry has also raised questions. This is due to fears that they have driven domestic firms to rework their ownership structure for attracting inflows in areas such as retail through the back door. The Department of Industrial Policy and Promotion (DIPP) is examining the issues raised. “The finance ministry has raised some generic issues and we should be able to address them properly,” said DIPP joint secretary Gopal Krishna.

India has long been seen as a draw for FDI, though its investment rules have been regarded as a drawback. It has grown substantially since 2005, driven primarily by domestic demand and low-cost operations for companies. DIPP has forecast positive inflows, saying they are likely to rise despite the ongoing global slowdown. India is expected to receive FDI of at least $40bn by early 2010, as against $37.5bn last year. Although inflows projected for 2009-10 does not spell a huge increase, it is considered a positive development, given the current crisis, says DIPP.

Krishna pointed out that fresh investment is expected to be $30bn by the end of March 2010, an increase of nine percent over the $27.5bn recorded in 2008-09. This means the rise in FDI will largely be due to fresh flows into the country as the reinvested earnings of multinationals operating in India are expected to remain at $10bn, the same as last year. Reinvested earnings represent investments made by Indian arms of foreign firms out of their earnings in India.

Clearing it up
Despite the upbeat forecasts regarding foreign direct investment, business leaders still say that there is too much confusion surrounding the rules changes nearly three months on. For example, they point out that there was little open discussion (apart from a series of confusing newspaper leaks) before the announcement. There is also doubt about what the net effects will be. Many government officials seem unsure, or are not admitting that they are sure, what will happen for example to the ban on foreign direct investment in multi-brand retailing such as supermarkets, the 74 percent cap on telecoms, and the 26 percent cap on foreign newspaper companies (though 100 percent foreign direct investment was approved on February 14 for facsimile editions of foreign newspapers). Officials are still remaining largely tight-lipped on whether foreign companies owning 49 percent in an Indian holding company take a large stake in the operating subsidiary of an airline, newspaper, or supermarket chain.

The changes are so complicated and confusing that the country’s financial press have lambasted the way the issue has been handled. The Economic Times newspaper dubbed the policy “irrational”, adding “don’t let sectional interests dictate norms”. It pointed out that even ardent supporters of foreign investment are “asking only one question – for whom is the government doing this?” The Business Standard said that “critics will… question the propriety of reforms by sleight of hand” because “definitional loopholes are being used to change foreign investment by executive order” in sectors previously regarded as controversial. It then dismissed “the manner and timing of the decision” as “side issues”, and said it was more important to ask whether the changes were beneficial.

While it is fair to say that the rules are still muddled – as are the intentions of the government to implement them – they no doubt represent the strongest indication yet that India could be open for new business from abroad.

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