India is contemplating an expansion of its foreign direct investment (FDI) policies to include a broader range of investment options as a means to counter its declining FDI inflows, which have hit a five-year low. The Indian government is reportedly considering permitting strategic foreign investments through a blend of equity and debt, an arrangement currently barred by foreign exchange regulations, according to sources familiar with the matter.
Key Considerations for Foreign Direct Investment (FDI) Policy Overhaul
- Inclusion of Mezzanine Instruments: Policymakers are exploring “mezzanine instruments” — financing mechanisms that combine equity and debt — as potential pathways to reinvigorate foreign investment. While common globally, such instruments are not presently recognized under India’s corporate financing and foreign exchange regulations.
- Flexible Investment Pathways: Allowing these blended instruments is expected to offer greater flexibility to foreign investors in large transactions, particularly in mergers and acquisitions, where a mix of capital is often advantageous.
Why the Focus on Foreign Direct Investment (FDI)?
FDI has been seen as a stable and reliable source of capital for India’s fast-growing economy. However, recent years have witnessed a decline despite the country’s steady economic growth, with the Reserve Bank of India (RBI) reporting gross FDI falling from $84.8 billion in 2021-22 to $71 billion in 2023-24. These numbers reflect India’s shrinking share of global FDI, which stood at 2.1% in 2023, down from a peak of 6.5% in 2020.
- Finance Ministry’s Support: The federal finance ministry, a key player in the policy landscape, has expressed favor for the proposed changes, though discussions remain at an early stage.
- Investment Goals: Finance Minister Nirmala Sitharaman recently stated India requires $100 billion in FDI annually to satisfy its investment demands, up from the current $70-80 billion.
Potential Economic Implications for Foreign Direct Investment (FDI)
The proposed inclusion of mezzanine financing could unlock an additional $20-30 billion in overseas inflows to the Indian economy. If implemented, this move would signal a significant liberalization in India’s capital market, attracting long-term foreign capital and potentially leading to further reforms in currency convertibility.
Benefits of Mezzanine Financing for Foreign Direct Investment (FDI) Investors:
- Enhanced Flexibility: Mezzanine instruments offer strategic investors a combination of debt-like stability with equity-like returns, potentially reducing entry and exit barriers.
- Easier Exit Options: According to Teena Goyal, an investment banker at En Pointe Adwisers, foreign investors often struggle to exit large equity stakes, while debt instruments are comparatively easier to liquidate. By enabling hybrid structures, India could attract a wider pool of global investors.
Concerns on Currency Volatility and Foreign Direct Investment (FDI)
While mezzanine financing could make Indian investments more attractive, it also raises concerns about potential currency volatility. The introduction of debt-linked instruments may lead to fluctuations in the rupee’s value, as foreign capital inflows would be partly tied to debt. Goyal noted that increased volatility could place additional pressure on the rupee, which may require the government to implement mitigating measures to manage currency stability.
Current Foreign Direct Investment (FDI) Regulations and Proposed Changes
Currently, foreign investors are allowed to acquire equity or securities that are mandatorily convertible into equity, subject to caps in sectors like banking and defense. Foreign debt, on the other hand, is governed by a distinct set of rules restricting loan costs and usage parameters. The proposed blended investment approach could streamline these channels, granting investors greater choice.
Existing Limitations in Foreign Direct Investment (FDI):
- Equity Investments: Limited by sector-specific foreign ownership caps.
- Debt Investments: Bound by rules on interest rates and purpose of funds.
Mezzanine Financing Proposal for FDI:
- Mixed Debt-Equity Option: Would enable foreign investors to diversify their holdings, combining the security of debt with equity’s growth potential.
- Sector-Specific Regulations: It remains unclear if the government would implement sector-specific guidelines for mezzanine investments, similar to those in place for current FDI channels.
Next Steps for Foreign Direct Investment (FDI) Policy Approval
The proposal awaits further discussion and approvals within India’s federal finance ministry and regulatory bodies, with potential rollout timelines yet to be determined. Industry experts expect that if the policy passes, it could represent a landmark shift for foreign investment in India, bringing the country closer to global capital market standards and potentially ushering in broader economic reforms.
As India takes steps to make foreign investment more attractive, industry players and economists alike will be watching closely to see if these reforms can reverse the recent FDI downturn, positioning India as a favorable destination in the global investment landscape.