The road ahead for FDI to meet India’s growth target

By Damini Bhalla and Akshay Jain, Luthra & Luthra Law Offices
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The prime minister, during “Make in India” week, urged investors to “seize the opportunity and invest” in India. The government’s drive to woo foreign direct investment (FDI) led to reforms in over 15 sectors in 2015 and FDI inflows rose by over 24% in the first half of the current financial year.

Damini Bhalla
Damini Bhalla

In addition to easing the regulatory framework for existing businesses and in line with the government’s focus on startups, the Department of Industrial Policy and Promotion recently notified the definition of “start-up”. Earlier, the Reserve Bank of India (RBI) had also clarified that startups can issue sweat equity shares without cash payment or issue equity shares against any legitimate payment owed to them where such remittance does not require any permission under the Foreign Exchange Management Act, 1999. Startups having overseas subsidiaries can open foreign currency accounts abroad to receive payments on behalf of such subsidiaries. These clarifications will help build an ecosystem conducive for the growth of startups, as envisaged by the RBI in its monetary policy statement issued last month.

Although policy liberalization has improved investor sentiment, some concerns in the FDI policy still need to be allayed to reinforce investor faith in India.

The right portfolio: With foreign portfolio investors (FPIs) pulling close to US$2 billion out of India in 2016, it is time to implement the finance minister’s recommendation in the 2014 budget speech that investments of up to 10% in a company’s capital be treated as FPI investments and exempted from stringent FDI conditionalities and sectoral caps, thereby aligning the Indian FPI regime with international practice.

Question of control: While the definition of “control” under the FDI policy is now aligned with other legislation, the core question of whether veto and affirmative rights amount to control is still an open issue.

Financial services: In addition to investment in financial services entities such as banks, asset reconstruction companies, insurance, etc., the FDI policy also permits FDI in 18 categories of non-banking financial companies. Investment in any other financial service requires government approval. With the global financial services sector offering varied specialized products, there is a need to recognize specific classes of financial services entities such as e-wallet services companies, mortgage guarantee companies, etc., as permissible entities for FDI.

Further, the financial services sector is heavily regulated and some non-fund based financial services are not capital intensive. FDI policy conditionalities such as minimum capitalization create additional hurdles for entrepreneurs seeking foreign capital. Easing such conditions would provide impetus to the government’s startup plan since this sector is being aggressively pursued by entrepreneurs to offer niche technology-driven financial services and products.

To make or to sell: The recent FDI policy reforms in single-brand retail trading permit an “Indian manufacturer” – i.e. one that owns an Indian brand, manufactures in-house in India at least 70% of its products, and sources at most 30% from other Indian manufacturers – to sell its own branded products in any manner, including retail and e-commerce. However, in reality, many Indian brand owners rely heavily on contract manufacturing or have ring-fenced their brand ownership by undertaking manufacturing through separate entities (which receive FDI). Unless such manufacturers significantly alter their business model to produce the requisite amount in-house, they will be unable to benefit from this clarification. Further, differentiating between manufacturers based on Indian or foreign ownership of brands creates more ambiguity and needs to be revisited.

Regulator overdose: The pharmaceutical sector has been left off the government’s recent policy liberalization agenda. The FDI policy restricts non-compete provisions in investment agreements in the pharmaceutical sector, unless approved by the Foreign Investment Promotion Board (FIPB), due to concerns of shrinking competition in the sector. Although Indian contract law generally prohibits non-compete restrictions, such clauses, subject to conditions, are permitted in business acquisitions. As the Competition Commission of India (CCI) is empowered to deal with competition concerns, giving the FIPB a discretionary power in this regard is a regulatory overlap.

Akshay Jain
Akshay Jain

Another sign of over-regulation is keeping “brownfield” investment in pharmaceutical sector under “approval route”. While aimed at reducing the risk of supply and pricing of drugs in India being controlled by a few international players, providing an additional level of clearance from the FIPB seems without much purpose, as the regulators such as CCI effectively handle these concerns under the merger control framework.

Thanks to the government’s policy liberalization, India is already one of the most favourable FDI destinations. However, changes such as simplifying approval procedures and reducing regulatory uncertainty need to match policy changes to achieve the goal of double-digit economic growth.

Luthra & Luthra Law Offices is a full-service law firm with offices in Delhi, Mumbai, Bangalore and Hyderabad. Damini Bhalla is a partner and Akshay Jain is an associate at the firm. The views of the authors are personal. This article is intended for general informational purposes only and is not a substitute for legal advice.

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