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2 Types of Capital Flows on Private Account


Here we detail about the two types of capital flows on private account.

The two types are: (1) Foreign Portfolio Investment, and (2) Foreign Direct Investment.

Type 1# Foreign Portfolio Investment:

This is important type of capital flow under which foreign institutions such as banks, insurance companies, companies managing mutual funds and pension funds purchase stocks and bonds of companies of other countries in the secondary markets (i.e., stock markets).


They get returns in the form of capital gains and yearly payable dividends but do not exercise any direct control in running these companies. Pension funds, mutual funds and insurance companies have been very active in moving portfolio capital in the last two decades because restrictions on foreign equity investment by various countries have been reduced or removed in recent years allowing pension and mutual funds and insurance companies to diversify their portfolio in order to reduce risk.

Besides, the growth of portfolio foreign capital in the last two decades has also been due to the policies of liberalisation followed by the developing countries. In India following the adoption of policy of liberalisation the flow of portfolio capital was permitted in 1991.

Consequently, foreign portfolio capital flows have come to India in large amounts in the last ten years (1991 – 2001). However, Mexico has been the chief beneficiary of portfolio capital flows. Portfolio capital flows now account for one third of net capital flows to the developing countries.

Benefits of Portfolio Capital Flows:

Benefits and costs of portfolio capital flows have been a subject of severe controversy. Private foreign portfolio investment in stocks, equities and bonds has been made by foreign investors in order to get higher return or higher interest on their investment and also to diversify their portfolio in order to reduce risk. Thus, Prof. Todaro rightly writes, “From the investor’s point of view, investing in the stock markets of emerging countries permits them to increase their returns while diversifying their risks.”


In the early 1990s the return on the portfolio investment in the so called ’emerging’ developing countries was quite high, for instance it was 39 percent during 1988-93 in Latin America which is main recipient of portfolio capital flows. But the high returns were marred by high volatility of stock markets of these countries.

Many mutual-funds based US companies which were lured by high returns had to suffer heavy losses when there was collapse of Mexican stock market following 35% devaluation of Mexican currency in Dec. 1994. The experience of these heavy losses resulted in drastic fall in portfolio capital flows in 1995 not only in Mexico but also in other developing countries. In fact, there was net capital outflows from the developing countries for some months.

From the perspective of developing countries private portfolio capital flows are generally considered as a welcome means for raising capital for private domestic companies. However, it has been argued whether it is prudent to rely on large and volatile private capital flows as they have a destabilising influence in both the financial markets and in the overall economy.

It has been pointed out that when the developing countries run into trouble, the portfolio capital flows disappear in few days as happened in case of Mexico in 1995 and recently in South East Asian countries in 1997-98. However, it may be noted that a developing country should not cover up its structural weakness by obtaining private capital flows.


If they want to ensure that there private portfolio capital flows continue occurring year after year on a sustained basis, they should manage the foreign exchange rates efficiently by controlling deficits on current account and also keeping adequate reserves of foreign exchange so that their currencies should not remain overvalued which might lead to severe long-term consequences.

From above it follows that private portfolio capital flows are welcome as they provide needed finance for developing countries and also bring in required foreign exchange. However, one should not consider them as substitutes for making structural changes in these economies such as maintaining exchange rate at the right level, controlling deficits in balance of payments, checking rate of inflation and adoption of proper monetary policy which should ensure relatively higher interest rates.

We agree with Prof. Todaro who while commenting on portfolio capital flows write, “Like multinational corporations, portfolio investors are not in the development business. If developed country interest rates rise or expected Third World profit rates decline, foreign speculator will withdraw their ‘investments’ as quickly as they brought them in. What LDCs need is true long-run economic investment (plants, equipment, physical and social infrastructure etc.) and not speculative equity capital.”

Type 2# Foreign Direct Investment (FDI):

The foreign direct investment (FDI) is the investment in the construction of physical capital such as building factories and infrastructure (i.e., power, telecom, ports etc.) in the capital- importing country. It may be done in several ways. Companies or corporations may be specially set up for the purpose in the capital-exporting country to carry out trade and industry in an under-developed country.

This is how the East Company operated in India or railways were constructed in India. The head office is in the investing country and the operations are in the developing country. Another method is that an already existing corporation spreads out its business in another country by establishing branches.

Thus, many foreign companies producing cars, colour TVs have set up branches in India and are producing these items in India. There is another way open to the foreign entrepreneur, that is, to form companies and register them in the borrowing country without having any connection in the lending country.

When India adopted protection, it became profitable, and quite fashionable too, for the foreign entrepreneurs to set up so called “India limited,” to jump over the tariff wall and to avail themselves of the various concessions which the government extended to national concerns.

These were in fact disguised branches of the foreign firms. The Indian match industry, for instance, is dominated by Swedish concerns. There is still another possibility which is now becoming common in India, viz., of joint ventures or joint participation. The foreign firms start industrial concerns in collaboration with Indian firms.

This form of foreign investment has some special advantages. The standing and reputation of foreign firms inspire confidence in the domestic and foreign capital. The long experience and efficient techniques are placed at the disposal of the domestic companies. It avoids evils of absentee ownership; it provides full opportunities for developing local skills, and also a large proportion of profits is retained in the country.


It is also advantageous to the foreign investor. He is able to ward off in this manner any danger of discriminatory treatment by the government. A developing country lacks capital for development and it will have to depend on foreign capital.

Merits of Foreign Direct Investment (FDI):

Several advantages can be claimed for foreign direct investment (FDI).

(1) Such investment does not burden the tax payer since no interest at fixed rate is to be paid as in the case of foreign borrowing. The foreign investor is compensated by the profit he gets.

(2) In private investment, the investor is actuated by the profit motive; hence the business operations are subjected to careful calculations. This is a guarantee that the capital resources are most efficiently employed and are not frittered away in some reckless investment as may happen in the case of borrowing.


(3) Direct investment by foreign companies introduces, in the developing country, new technology, modern skills, innovations and new ideas. This is a great gain because the developing country is backward in technology and skills. The local entrepreneurs take a clue and start similar concerns. The Indian cotton textile industry was inspired by the Indian jute industry established by British entrepreneurs. Thus, direct foreign investment serves as an instrument for transferring modern technology to the developing countries.

(4) Another advantage is that a part of the profit is ploughed back into business and is not drained off from the country as it happens in the case of portfolio investment. The profits are invested either in modernisation and expansion of existing concerns or for establishing ancillary or subsidiary concerns in related fields. There is thus a continuing advantage for the developing country.

(5) Foreign direct investments are most likely to flow into export industries. By increasing exports and reducing imports, it will improve balance of payments of the developing country. It has a specially favourable effect on balance of payments position during recession because direct investment is serviced by dividends which are related to profits and not by fixed interest charges as in the case of loans. This flexibility of pressure on the balance of payments is of great advantage.

(6) Even otherwise flexible return on direct investment is a great advantage as compared with rigid interest and amortization requirements associated with public foreign loans.


(7) Direct foreign investment induces domestic investment also either in the form of joint participation or in local ancillary industries. Thus, foreign capital activates otherwise inert domestic capital. The domestic capital sheds off its shyness and enters into fields opened by direct foreign investment.

(8) The direct foreign investment makes a real addition to the productive capacity of the capital importing country. There is no question of foreign capital coming in this form being used for unproductive purposes. In the case of other types of foreign borrowings, there is nothing to prevent them from being utilised unproductively.

(9) Another important advantage of direct foreign capital is that it can be induced to be invested in infrastructure such as power, telecom, development of ports which is an obstacle to accelerating economic growth in the developing countries.

Such direct foreign investment enables the developing countries to overcome supply-side bottlenecks which will spur domestic investment. It should be mentioned that in recent times the Indian Government has been wooing foreign investors to invest in the infrastructure sector. The foreign companies have the resources, technology and technical knowhow to start productive ventures in the infrastructure.


(10) The capital that comes through foreign direct investment has a distinct advantage over portfolio investment. While foreign institutional investors can sell their shares and take capital out of the developing countries in a very short time and thus destabilize these economies as re­cently happened during East Asia Crisis, it is not easy to close down foreign concerns established through direct investments. Foreign Direct Investment (FDI) enters the developing economics to build factories and these factories (i.e., physical capital) stay even if the investors decide to sell out later to domestic buyers.

The direct foreign investment (DFI) is opposed on the ground that it seeks to establish ‘financial imperialism’. It leads to political domination and economic exploitation. That is why foreign capital was so unpopular in India. The strength of this objection really rests on the nature of political set up. A free democratic country of the continental size such as India need not entertain such fears.

In order to promote private foreign direct investment, it is necessary both for the lending and borrowing countries to remove the impediments to free flow of capital and to grant the necessary facilities. The borrowing country should guarantee immunity from nationalization and repatriation of profits.

The crux of the problem is to assure higher returns and minimum risk. At present investment is deterred by political and social instability, uncertainty about the jurisdic­tion of courts, exchange controls and currency inconvertibility, controls on capital issues, fear of discriminatory legislation and fear of nationalization, the practice of shutting out some industrial fields for foreign investors, employment of nationals in superior posts etc.

Among the measures to minimise risks and allay fears may be mentioned investment treaties, government guarantees, tax incentives, joint ventures, relaxation of restrictions and granting of concessions.

In short, the investment climate must be made most favourable by ensuring the following:

(i) Political stability and freedom from external aggression.

(ii) Security of life and property.

(iii) Availability of opportunities for earning profits.

(iv) Prompt payment for fair compensation and its remittance to the country of origin in the event of compulsory acquisition of a foreign enterprise.

(v) Facilities for the remittance of profits, dividends, interest, etc.

(vi) Facilities for the immigration and employment of foreign technical and administrative personnel.

(vii) A system of taxation that does not impose an excess burden on private foreign enter­prise.

(viii) Freedom from double taxation.

(ix) A general spirit of friendliness for foreign investors.

The department of commerce of the United States mentions certain factors which stand in the way of private investment of American capital are uncertainty created by the present political situation, the policies and practices with respect to foreign investment, the relatively low level of economic infrastructure and the lack of trained labour, and the limited knowledge of the developing countries on the part of American businessmen.

The particular impediments mentioned in the case of India are the nature of India’s screening policy shutting out foreign investment in certain spheres and controls on imports, exports and foreign exchange and the absence of a double taxation agreement, obligation to employ and train Indian labour.

India also offers some special inducements, e.g., special tax exemptions, increased depreciation allowance and other benefits available to domestic industry, guarantee of exchange facilities for profit remittances, capital repatriation and import of essential requirements, government assistance in the acquisition of land, transport facilities, etc., the right to hold controlling interest.

This compares quite favourably with many other countries. But there are still some countries with more attraction in the form of higher returns and better guarantees and they can absorb a substantial supply of foreign U.S. capital.

However, in the opinion of the present author direct foreign investment in the field of infrastructure in India may not be as much as expected because infrastructure projects relating to power, telecom, ports are of the nature of public utilities and therefore, the price of their end- product (for example, electricity charges) have to be controlled which may not yield sufficient profits to attract foreign investment.

Reforms in Foreign Investment Policy:

Policy of economic liberalisation pursued since 1991 also involved changes in foreign investment policy. Until 1991 foreign investment played a minimal role in India’s growth process. The current account deficit during 1980s was met largely by external commercial borrowing, external assistance and inflows under non-resident bank deposits.

All these three types of capital inflows were of debt-creating nature which created problem in paying them back. However, since the initiation of economic reforms foreign investment, both foreign direct investment and portfolio investment through investment by FII in the Indian equity and debt securities, has also played an important role.

Foreign investment has been sought by India for three reasons. First, foreign investment increases the total investible resources for accelerating capital formation. Second, foreign investment can be utilised for developing physical infrastructure which is badly needed for achieving a higher rate of economic growth. Third, foreign investment is expected to bring advanced technology and modem managerial skills which are required for technological un-gradation of the Indian economy. To attract foreign investment various reforms were made in India’s foreign investment policy.

Prior to 1991 foreign investment was restricted to certain priority sectors and foreign investment was permitted up to only 40 per cent of equity capital of a business enterprise. This was relaxed under liberalized foreign investment policy. Under this, foreign direct investment (FDI) upto 51 per cent of equity capital of a company was allowed in 34 high priority industries under automatic approval route. Besides, foreign equity participation up to 100 per cent equity capital of a production unit was allowed in 100 per cent export-oriented units (EOUs).

Another important foreign investment policy reform is that for infrastructure projects such as building of roads, highways, ports and harbours and vehicular tunnels and bridges, foreign equity participation up to 100 per cent subject to the maximum of Rs. 1500 crores has been allowed under automatic approval route. In case of 100 per cent foreign equity participation in projects involving electricity generation, transmission and distribution, the upper limit of Rs. 1500 crores has been withdrawn.

Furthermore, foreign investment in equity capital up to 100 per cent in e-commerce, oil refining, and drugs and pharmaceuticals, 49 per cent in telecommunication, 50 per cent in mining, 50 per cent in hotels and tourism has been allowed. The foreign direct investment under automatic approval route has been permitted up to 100 per cent for all manufacturing activities in Special Economic Zones (SEZs) except certain specified activities.

Even insurance and banking have been opened up to foreign investment and many foreign banks and insurance companies have opened their own branches and also invested in other private banks. Another important foreign investment reform has been that the registered foreign institu­tional investors have been permitted to buy equity and debt securities directly in the Indian capital market.

Last but not the least important reform has been that Indian firms of good standing have been permitted, with government approval, to issue equity and convertible bonds through Global Depository Receipts (GDRs) and American Depository Receipts (ADRs) respectively in European and American markets. Recently in 2006, retail foreign investment in single foreign brands has been permitted. It is evident from above that foreign private investment has been liberalized to the same extent.

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