Why in the News?

The RBI Bulletin (May 2025) reports that India received a record-breaking $81 billion in gross FDI inflows in FY 2024-25, but retained only $353 million in net FDI, revealing a dramatic divergence in the investment narrative.

What do gross and net FDI trends indicate about India’s investment climate?

• Gross FDI inflows are high: India received a record $81 billion in gross FDI in 2024-25, indicating strong headline interest from foreign investors. Eg: Media and government reported this as a sign of a robust investment climate.
• Net FDI is drastically low: Net FDI dropped to only $353 million, showing that much of the incoming investment is offset by capital outflows, weakening the real impact on the economy. Eg: Rising outward FDI and disinvestment reduced net foreign capital retained in India.
• Declining FDI-to-GDP ratio: The gross inflow-to-GDP ratio fell from 3.1% (2020-21) to 2.1% (2024-25), and net FDI-to-GDP fell from 1.6% to near zero, reflecting a slowing domestic investment environment despite high gross inflows. Eg: This signals tepid corporate investment and cautious investor sentiment in India.

Why is the rise in Private Equity (PE)/Venture Capital (VC) driven FDI a concern for long-term investment?

• PE/VC-driven FDI focuses on brownfield investments: These funds mainly acquire existing firms rather than creating new production capacity, limiting contributions to capital formation and technology acquisition. Eg: Investments by Blackstone in Care Hospitals and ChrysCapital in Lenskart.
• Short investment horizon: PE/VC funds typically have a 3-5 year exit strategy, often selling holdings during stock market booms, which leads to disinvestment rather than sustained growth. Eg: The spike in disinvestment in FY25 was partly due to PE/VC funds liquidating their positions.
• Limited impact on long-term industrial growth: Since these funds focus on services like fintech and retail rather than manufacturing or infrastructure, they contribute less to enhancing India’s productive capacity. Eg: The declining share of FDI in greenfield projects shows limited greenfield capital formation.

How does outward FDI suggest India is used for tax arbitrage?

• High correlation between inward and outward FDI: India shows a strong link between the money flowing in and out, suggesting that funds often enter and exit quickly rather than being invested long-term. Eg: Similar volumes of FDI both coming into and going out of India.
• Use of tax havens as intermediaries: A significant portion of both inward and outward FDI involves countries like Singapore and Mauritius, known for tax concessions and treaty benefits. Eg: Many Indian companies route investments through these jurisdictions to reduce tax liabilities.
• ‘Treaty shopping’ for tax benefits: Global investors move capital through India to exploit variations in tax laws, a practice called tax arbitrage, which may not contribute to domestic economic growth. Eg: Research shows India ranked 6th among emerging markets for such correlated FDI flows, indicating use as a conduit for tax optimization.

What are the effects of declining FDI-to-GDP and GFCF ratios?

• Reduced contribution to economic growth: Declining FDI-to-GDP and FDI-to-GFCF (Gross Fixed Capital Formation) ratios indicate that foreign investments are becoming a smaller part of India’s overall economy and capital investment, potentially slowing down industrial expansion and technology adoption. Eg: Gross FDI inflows peaked at 7.5% of GFCF in FY21 but have declined sharply since then.
• Weakening investor confidence: The downward trend signals tepid domestic corporate investment and reduced foreign investor interest, which can affect job creation and long-term economic stability. Eg: Net FDI relative to GDP has declined from 1.6% in 2020-21 to nearly zero in 2024-25, showing declining investor enthusiasm.

Why should India reform its foreign capital regulations?

• To curb tax arbitrage and ‘hot money’ flows: Current regulations allow large volumes of inward and outward FDIthrough tax havens, enabling tax optimization rather than genuine investment, which undermines domestic economic goals. Eg: High FDI flows involving Singapore and Mauritius reflect such practices.
• To promote long-term, productive investments: Reform is needed to encourage FDI that contributes to capital formation, technology acquisition, and industrial growth rather than short-term PE/VC-driven disinvestment. Eg: The rising share of alternative investment funds in FDI has led to increased disinvestment, affecting sustainable growth.

Way forward: 

• Strengthen Regulatory Frameworks: Implement stricter rules to curb tax arbitrage and limit quick inflows and outflows via tax havens, ensuring FDI supports genuine, long-term economic growth.
• Promote Greenfield and Productive Investments: Encourage FDI in new capacity building, manufacturing, and technology sectors over short-term PE/VC deals to boost capital formation, industrial growth, and sustainable development.

Mains PYQ:

[UPSC 2013] Though India allowed Foreign Direct Investment (FDI) in what is called multi-brand retail through the joint venture route in September 2012, the FDI, even after a year, has not picked up. Discuss the reasons.

Linkage: The net FDI-to-GDP ratio has steadily fallen from 1.6% in 2020-21 to zero in 2024-25. This ongoing decline is worrying, even though policymakers continue to make optimistic claims.

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