Stick to the line of control

Financial Express, 27th May 2013

Just redefine foreign investments by whether or not they seek to control the company they are in

Indian capital controls are amongst the most complex in the world. In this area the Indian bureaucracy blindly marched on in the spirit of the licence permit raj of the 1970s. Today, the system has become so tangled that it is difficult to implement all the various conflicting rules in place. Simplifying the system requires implementing the UK Sinha working group on foreign investment through current initiatives such as the Sebi working group on QFI, and the Arvind Mayaram group on FDI definition.

The gentle reader is requested to read the next few tortuous paragraphs, in order to get a sense of the scale of complexity that has been constructed in the Indian capital controls. Foreign investment into India has been cut up into a maze of categories. Foreign investors are classified as: Foreign Institutional Investors (FIIs), Foreign Venture Capital Investors (FVCIs), Non-Resident Indians (NRIs), Qualified Foreign Investors (QFIs) and Foreign Direct Investors (FDI). FDI includes a sub-route involving issuing ADRs/GDRs or foreign currency convertible bonds. Sebi, RBI and the finance ministry make rules and regulations governing foreign investment. Investment by each subcategory of investors in each sector has to be continuously monitored.

The FDI framework consists of acts, regulations, press notes, press releases and clarifications, etc. The Department of Industrial Policy and Promotion (DIPP), ministry of commerce & industry, frames policy on FDI through press notes which are notified by RBI as amendments to the FEMA regulations. To bring some clarity, DIPP attempts to consolidate the various circulars on FDI in a consolidated policy statement (which has unclear legal authority). Often, it seems to get tangled in the issues with other routes of investment. While FDI is permitted up to 100% in most sectors under the automatic route, in other sectors there are sectoral investment caps.

In addition, the rules cross reference each other. For example, RBI regulations on FIIs state that an individual FII can purchase up to 10% of the equity of a company and all FIIs together can hold up to 24%. In addition, there are caps for NRIs and QFIs. The same regulations give an option to the company to raise the aggregate FII limit from 24% to the sectoral limit prescribed by the FDI policy. Similarly, when the DIPP issues press notes governing FDI limit, it states the FII investment limit should stay within the caps on foreign direct investment. In some cases, the consolidated FDI policy overrides the regulations made by RBI. In print media, the foreign investment limit is 26%, which includes the limit by NRIs/FIIs/PIOs. This means that if a company with an FDI of 20% lists on the exchanges, FIIs and other portfolio investors will be allowed to the extent of only 6%. This contradicts the RBI regulations which state that FIIs can purchase up to 24% of equity of a listed company.

Similarly, if a foreign investor invests in the same company through both the QFI route and the FDI route, the total holding of the person in such a company cannot exceed 5% of the paid up equity capital of the company, at any point of time irrespective of the sectoral cap, if any. In addition, regulations often restrict FII/NRI/QFI investments in a company at various arbitrary limits and cap their total limit to the FDI limit.

The regulatory framework is further complicated by the lack of clarity on the nature of instruments classified as FDI. As an example, if a company raises funds through the issue of ADRs/GDRs, the resultant foreign investment is considered to be part of FDI. ADRs/GDRs are largely equity instruments and investments through these do not qualify as 'control' by the foreign investors as these instruments do not give voting rights to the investors.

This tangled mess is typical of everything that India did wrong in economic policy in previous decades. Just as we have simplified industrial licensing (by eliminating it) or indirect taxation (by moving to a single rate GST), we need to drastically simplify capital controls so as to reduce transactions costs, and shift the focus of the field away from fixers to genuine investors.

In the Budget speech 2013, the finance minister announced that India will follow international best practices in defining FDI and FII. According to OECD and UNCTAD norms, a stake of less than 10% should be classified as FII. The government proposes to provide clear definitions to FDI and FII, with an aim to remove ambiguity over the two types of foreign investments.

The key step is that of clarifying the objective of the FDI/FII classification and regulations. If the objective of regulations is to prevent foreigners from taking control of an Indian company (due to national security, politics, infant industry arguments, etc) then the regulations should not take into consideration the amount of portfolio investments in the company, since such investments are not for the purpose of control of the Indian company. The regulator may choose to classify any single large investor (say, above 10) as one seeking control and bring him under the limit, but overall limits for portfolio investment do not serve this purpose.

A simple solution of redefining the different foreign investment routes is by dividing investment into two categories: investment which is related to foreign control of the Indian companies and investment which does not lead to control of an Indian company. Under this system, the FII or, say, QFI investment will not be considered for FDI limits. It will simplify both the calculation of limits for FDI and the monitoring costs. The investments which do not lead to control of the Indian company should then be subject to a uniform registration requirement with emphasis on robust KYC norms.

(Co-authored with Radhika Pandey of NIPFP)