Difference & Relationship between – FDI, FPI/FII

Dear Aspirants,

Today we are providing you an article on ‘FDI & FPI’ which is an important topic of Banking Affairs. The article is important for upcoming exams.  

Introduction

Capital is a vital ingredient for economic growth but since most nations cannot meet their total capital requirements from internal resources alone, they turn to foreign investors.

The two of the most common routes for investors to invest in an overseas economy are – Foreign Direct Investment (FDI) and Foreign Portfolio investment (FPI) / Foreign Institutional investor (FII).

Note:

• FDI implies investment by foreign investors directly in the productive assets of another nation.
• FPI / FII means investing in financial assets, such as stocks and bonds of entities located in another country.

Foreign Investments

Any investment that flows from one country into another is known as foreign investment. The inflow of investment from other countries complements and leads to domestic investments in capital-scarce economies.

In India, Foreign investments are allowed to take the form of investments (through the capital market) in listed companies referred as FII / FPI investments and investments in listed/unlisted companies other than through Exchanges, are referred as FDI.

About FDI (Foreign Direct Investment)

FDI refers to an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor.

• In cases of FDI, the investor´s purpose is to gain an effective voice in the management of an enterprise.
• In other words, companies making such direct investments have a significant degree of influence and control over the company into which the investment is made.
• The foreign entity or group of associated entities that make an investment is termed as direct investor.
• The unincorporated or incorporated enterprise-a branch or subsidiary, respectively, in which direct investment is made is referred to as a direct investment enterprise.

Some degree of equity ownership is almost always considered to be associated with an effective voice in the management of an enterprise. A threshold of 10 percent of equity ownership is required to qualify an investor as a foreign direct investor. 

NEED of FDI

• FDI serves as an important source to fulfill the gap between income and savings, in technology up gradation and efficient exploitation of natural resources along with the development of basic infrastructure.
• It improves the balance of payment condition and helps the recipient firms to cope competition in better ways.
• FDI brings better technology and management, marketing networks and offers competition.

Determinants 

The main determinants of FDI in India are stable policies in favor of foreign investment, favorable economic factors like interest loan subsidies, removal of restrictions, tax exemptions, availability of cheap and skilled labor and in spite of being a developing country reasonably developed infrastructure like roads, information, and communication networks.

Foreign Portfolio investment (FPI)

Foreign Portfolio investment represents passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities‘ issuer by the investor; where such control exists, it becomes FDI.

Some examples of portfolio investment are:

• Purchase of shares in a foreign company.
• Purchase of bonds issued by a foreign government.
• Acquisition of assets in a foreign country.

Determinants 

Factors affecting international portfolio investment:

• tax rates on interest or dividends (investors will normally prefer countries where the tax rates are relatively low)
• interest rates (money tends to flow to countries with high-interest rates)
• exchange rates (foreign investors may be attracted if the local currency is expended to strengthen) Portfolio investment is part of the capital account on the balance of payments statistics

Foreign Institutional Investor (FII)

FII investment helps Indian companies to improve performance. Steps were taken to allow foreign portfolio investments into the Indian stock market through the mechanism of foreign institutional investors.

An institutional investor is an investment entity, one who proposed to invest their proprietary funds or on behalf of road-based funds or of foreign corporates and individuals and belong to any of the under given categories can be registered for FII:

• Pension Funds
• Mutual Funds
• Investment Trust
• Insurance or reinsurance companies
• Endowment Funds
• Trustees
• Bank

NEED of FII

• To create non-debt creating foreign capital inflows and also to develop the Capital market in India, lower the cost of capital for Indian enterprises and indirectly improve corporate governance structures.
• Therefore a developing country like India adopts two strategies at the same time one to attract FDI  and the second strategy is to encourage portfolio capital flows which provide the financing means to Indian enterprises.
• FII had an important role in the building of currency reserves of India, The Major source of their investment is in the form of participatory notes (P notes) also commonly known as offshore derivatives.

Similarities

• The two forms ( FDI & FPI/FII ) of investments have two things in common: Origin – Foreign and Activity – Investment.

Dissimilarities

Fundamental differences between the two:

1. The first difference arises in the degree of control exercised by the foreign investor.

• FDI investors typically take controlling positions in domestic firms or joint ventures and are actively involved in their management.
• FPI investors, on the other hand, are generally passive investors who are not actively involved in the day-to-day operations and strategic plans of domestic companies, even if they have a controlling interest in them.

2. The second difference is that

• FDI investors perforce have to take a long-term approach to their investments since it can take years from the planning stage to project implementation.
• On the other hand, FPI investors may profess to be in for the long haul but often have a much shorter investment horizon especially when the local economy encounters some turbulence.

3. The third difference is that –

• FDI investors cannot easily liquidate their assets and depart from a nation, since such assets may be very large and quite illiquid.
• FPI investors can exit a nation literally with a few mouse clicks, as financial assets are highly liquid and widely traded.

4. The Fourth difference is that

• Foreign portfolio investments (FPI/FII) are more difficult to manage than foreign direct investments (FDI) since they are very volatile and have the capacity to get affected both by domestic and external factors.

The relationship between FDI & FPI/FII

Every investor looks for maximization of returns, irrespective of category – shareholder (FPI) or Owner (FDI). Which leads to the questions – Is there any connection between them, any causal relationship, and any time gap before the causal effect sets in, any long run association etc.

• The various studies found that the inflow of FDI is contingent on the development of physical infrastructure and that of FPI on financial development (sound monetary policy and stronger oversight in the financial system).
• From the point of an investor – whether investing in firms of host country should be through FDI or FPI route. There was one striking observation – “that firms adjust to short-term changes via FPI and keep FDI stable.
• FPI can prop up small and medium-sized changes and therefore, the valuation of FDI with combined FPI is higher than of isolated FDI.
• Hence, a combined FPI and FDI investment strategy increases the firm’s flexibility.
• A combination of both investment instruments increases the valuation of the respective instruments.”

Example: You are trying to decide between:

(a) acquiring a company that makes industrial machinery, and

(b) buying a large stake in a company that makes such machinery.

The former is an example of FDI while the latter is an example of FPI.

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Thanks

Team Gradeup