Decision Concerning Foreign Direct and Portfolio
Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) are the two important forms of foreign capital. The real difference between the two is that while FDI aims to take control of the company in which investment is made, FPI aims to reap profits by investing in shares and bonds of the invested entity without controlling the company.
Both FDI and FPI are the most well sought type of foreign capital by the developing world. Usually, both these are measured in terms of the percentage of the shares they own in a company (ie., 10%, 20% etc.,).
According to the existing regulation by the SEBI, FPI is investment in shares of a company not exceeding 10% of the total paid up capital of the company. Any investment above 10% is FDI as with that size of shareholding, the foreign investor can exert control in the management of the company.
A marvellous advantage of both FDI and FPI is that the receiving country need not repay the debt like in the case of External Commercial Borrowings (foreign loans). Both are thus described as non –debt creating, and hence involve no payment obligations. Their own servicing depends on future growth of the economy. This is why most developing countries prefer FDI and FPI compared to other forms of foreign capital like ECBs.
The similarity between the two ends here. A one-to one comparison will reveal that FDI is superior to FDI from the angle of a developing country like India.
Foreign Direct Investment (FDI)
FDI is investment by non-resident entities like MNCs to carryout business operations in India with management of investment, production of goods or services, employing people and marketing their products. In FDI, both the ownership and control of the firm is with the investor. The foreign investor usually takes a considerable stake or shareholding in the company and exerts management influences completely or partially, depending on his shareholding.
Foreign Portfolio Investment (FPI)
FPI on the other hand is investment in shares, bonds, debentures, etc. According to the IMF, portfolio investment is defined as cross-border transactions and positions involving debt or equity securities, other than those included in direct investment or reserve assets.
FDI vs. FPI: Of the two, FDI is more desirable
FDI means real investment; whereas FPI is monetary or financial investment –Here, FDI means the investor makes investment in buildings and machineries directly in the company in which he has made the investment. FPI doesn’t create such productive asset creation directly. It is just financial investment. FDI is certain, predictable, takes production risks, have stabilizing impact on production. It directly augments employment, output, export etc. The major merit of FDI is that it is non debt creating as well as non-volatile (less fluctuating).
FPI on the other hand is investment aimed at getting profits from shares, interests from deposits etc. It is otherwise known as hot money. The portfolio investors stays his money in the capital market only for a short period of time. Its destination period is so small and is empirically considered as fluctuating (often short term) capital. It is highly volatile, a fair weather friend, speculative, involves exchange risks and may lead to capital flight and currency crisis affecting real economic variables. It is destabilizing in the foreign exchange market. Fluctuations in the mobility of FPI affects foreign exchange rate, domestic money supply, value of rupee, call money rates, security market etc. FII (Foreign Institutional Inflows) inflows depend on two factors: first, return potential of the destination market (host country) and second availability of risk capital at source geographies (home market; countries like the US). A change in environment in any of these will result in quick reversal of the flows.
If FDI is certain, long term and less fluctuating, FPI is speculative, highly volatile and un-predictive. Hence, FDI is superior to FPI.