Thursday, November 12, 2015

The new FDI policy: Well begun is not half done

by Bhargavi Zaveri and Radhika Pandey

A recent press release issued by the Central 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.

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 post 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 forced through 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.

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